Estimate and interpret the degree of operating, financial, and combined leverage of A Ltd. And B. Ltd. based on the following data:
A Ltd. (Rs.) B Ltd. (Rs.)
Sales 16,00,000 20,00,000
Fixed Costs 5,00,000 10,00,000
Variable expenses are 40% of sales for firm A and 25% for firm B. Interest expenses are ₹ 1,60,000 for A Ltd. and ₹ 2,00,000 for B Ltd.
First, let's calculate the operating leverage for both firms.
Operating Leverage = Contribution Margin / Operating Income
For firm A Ltd.:
Contribution Margin = Sales - Variable Expenses
= ₹16,00,000 - (40% * ₹16,00,000)
= ₹9,60,000
Operating Income = Sales - Variable Expenses - Fixed Costs
= ₹16,00,000 - (40% * ₹16,00,000) - ₹5,00,000
= ₹3,60,000
Operating Leverage for A Ltd. = ₹9,60,000 / ₹3,60,000
= 2.67
Interpretation: A Ltd. has an operating leverage of 2.67, which means that a 1% change in sales will lead to a 2.67% change in operating income.
For firm B Ltd.:
Contribution Margin = Sales - Variable Expenses
= ₹20,00,000 - (25% * ₹20,00,000)
= ₹15,00,000
Operating Income = Sales - Variable Expenses - Fixed Costs
= ₹20,00,000 - (25% * ₹20,00,000) - ₹10,00,000
= ₹5,00,000
Operating Leverage for B Ltd. = ₹15,00,000 / ₹5,00,000
= 3
Interpretation: B Ltd. has an operating leverage of 3, which means that a 1% change in sales will lead to a 3% change in operating income.
Next, let's calculate the financial leverage for both firms.
Financial Leverage = Operating Income / Earnings Before Interest and Taxes (EBIT)
For firm A Ltd.:
EBIT = Operating Income + Interest Expenses
= ₹3,60,000 + ₹1,60,000
= ₹5,20,000
Financial Leverage for A Ltd. = ₹3,60,000 / ₹5,20,000
= 0.69
Interpretation: A Ltd. has a financial leverage of 0.69, which means that a 1% change in EBIT will lead to a 0.69% change in operating income.
For firm B Ltd.:
EBIT = Operating Income + Interest Expenses
= ₹5,00,000 + ₹2,00,000
= ₹7,00,000
Financial Leverage for B Ltd. = ₹5,00,000 / ₹7,00,000
= 0.71
Interpretation: B Ltd. has a financial leverage of 0.71, which means that a 1% change in EBIT will lead to a 0.71% change in operating income.
Finally, let's calculate the combined leverage for both firms.
Combined Leverage = Operating Leverage * Financial Leverage
For firm A Ltd.:
Combined Leverage = 2.67 * 0.69
= 1.84
Interpretation: A Ltd. has a combined leverage of 1.84, which means that a 1% change in sales will lead to a 1.84% change in operating income.
For firm B Ltd.:
Combined Leverage = 3 * 0.71
= 2.13
Interpretation: B Ltd. has a combined leverage of 2.13, which means that a 1% change in sales will lead to a 2.13% change in operating income.
In summary, A Ltd. has a higher operating leverage, financial leverage, and combined leverage compared to B Ltd. This indicates that A Ltd. is more sensitive to changes in sales and has a higher potential for both gains and losses in operating income.