Question

Explain the relationship between profitability and the amount of financial leverage a company can safely manage?

Please provide a detailed explanation and illustrate with examples.

Answer 1

Profit and Profitability are used synonymously even though the two differs conceptually. Profit is amount remain after dedcuting all cost with Revenue earned. This is the amount appears in every company Statement of Profit and loss.

While profit is absolute amount, profitablity is relative one. It is the mextric used to determine the scope of the Company's profit in relation to the size of the business. Profitablity is the ability od the business to produce a return on investment based on its resources.

Financial leverage is the use of borrowed money to increase the production valume and there by increasing the sales valume and profits. Financial leverage is calculated using the formuala:

Total Debt / Total Assets

The greater the amount of debt higher the Financial leverage. Financial leverage has positive impact on firms return on equity given the earning power of the firm's asset is greater than the cost of Interest on debt.

Financial leverage allowes companies and business to grow sales and profitabilty withour increasing the equity there by allows higher payment of dividend. However, higher financial leverage comes with fixed cost in the form of Interest. As company increases debt and prferred equities, interest payment increases. Increase in Interest means reduced EPS. Thus A company should keep optimal capital structure which increases the value of the Company.

The formula for calculating a Companies Degree of Financial Leverage( DFL) measures the percentage change in earning per share over the percebtage change in EBIT. DFL is the measure of the sensitivity of EPS to change in EBIT as a result of change in Debt. It is calculated using the following formula:

EBIT/ (EBIT- Interest)

If Interest is 0( Zero) then DFL will be one

Exemple:

Particulars		Amount( USD)	Change in EBIT	Change in EPS
Annual Sales		4,700,000
Varibale cost		2,115,000
Contribution margin		2,585,000
Fixed Cost		1,500,000
EBIT		1,085,000	1302000
Interest payment		250,000	250,000
Profit		835,000	1,052,000
No.shares outstanding		100000	100000
EPS		8.35	10.52	26%
DFL	EBIT/ ( EBIT- Interest)
DFL		1.2994	1.24	25.99
An increase in EBIT by 20% DFL indicates EPS will increase by 26%. If you multiple % of increase in EBIT by DFL it will give % increase in EPS