Question

The Omani Company has OMR (800) thousand of total debt (Liabilities) outstanding (Liabilities), and it pays an interest of OMR (80) thousand annually. Company’s annual sales are OMR (4) million, its tax rate is 20%, and its rate on equity (ROE) is 20% and tota asset (TA)was OMR (1500) thousand. Omani Company sold product at OMR (6) per unit; its variable operating costs are OMR (2) per unit.

Answer the following:-

1. Calculate the firm’s degree of Operating leverage.
2. Calculate the firm’s degree of financial leverage.
3. What is the combine effect of fixed Operating and Financial Costs?

Answer 1

Answer to Q-a.

The degree of operating leverage (DOL)

It is a financial ratio that measures the sensitivity of a company’s operating income to its sales. This financial metric shows how a change in the company’s sales will affect its operating income.

The degree of operating leverage is a method used to quantify a company’s operating risk. This risk arises due to the structure of fixed and variable costs. Fixed costs do not allow the company to adjust its operating costs. Therefore, operating risk rises with an increase in the fixed-to-variable costs proportion.

Particulars	Amount
Selling price (P)	6
Less:-Variable cost (V)	(2)
Contribution per unit	4
Fixed cost (F)	80,000
Total sale given	40,00,000
No of units(sales/selling price per unit) - (Q)	=4000000/6
6,66,667

Degree of operating leverage =	Q (P-V)	666667*(6-2)
666667(6-2) - 80000
Q – the number of units
P – the price per unit	Q (P-V)-F	=2666668 / 2586668
V – the variable cost per unit	= 1.0309
F – the fixed costs

The DOL indicates that every 1% change in the company’s sales will change the company’s operating income by 1.03%.

Answer to Q-b.

The degree of financial leverage (DFL)

It is a financial ratio that measures the sensitivity in fluctuations of a company’s overall profitability to the volatility of its operating income caused by changes in its capital structure. The degree of financial leverage is one of the methods used to quantify a company’s financial risk.

Degree of financial leverage =	EBIT
	EBIT - Interest
Particulars	Amount
Sales (given)	40,00,000
Less:-Variable cost (2*666667)	13,33,334
Contribution	26,66,666
Less:- Fixed cost	80,000
Earnings berfore interest and tax (EBIT )	25,86,666
Interest	80,000
Earnings berfore interest and tax - Interest	25,06,666
Degree of financial leverage =	=2586666/2506666
1.0319

It shows that a 1% change in the company’s leverage will change the company’s operating income by 1.03%.

Answer to Q-c

The degree of combined leverage (DCL)

It is a ratio that summarizes the effect of both operating and financial leverage. This ratio shows the percentage change in earnings per share (EPS) caused by a 1% change in sales. The higher its value, the more vulnerable a company is for a decrease in sales.

The combined leverage summarizes the effect of fixed operating costs and fixed financial costs on a company’s earnings per share (EPS). That ratio is a measure of the total risk of a business because it includes both operating risk and financial risk.

A high value DCL ratio means that a large proportion of a company’s total costs are fixed, and incremental sales will result in a higher incremental EPS. Other things being equal such companies have to generate more sales to cover their total fixed costs.

A smaller proportion of fixed operating and financial costs will result in a lower value DCL ratio, which means lower incremental EPS on incremental sales and lower sensitivity to the slippage in sales.

Solution - DCL = DOL × DFL = 1.0309*1.0319 = 1.064

Degree of combined leverage (DCL)

Degree of financial leverage (DFL)

Degree of operating leverage (DOL)