Question

CH13

Leverage refers to the use of fixed costs to increase the return to shareholders. Operating leverage is the use of fixed operating costs such as fixed cost of goods sold and depreciation to magnify the earnings before interest and taxes.

The degree of operating leverage (DOL) = % change in EBIT / % change in Sales.

Financial leverage refers to the use of fixed financing costs such as long-term debts to magnify the return to shareholders.

The degree of financial leverage (DFL) = % change in EPS / % change in EBIT.

And the degree of total leverage = % change in EPS / % change in sales

or DTL = DOL x DFL.

Use the following information to calculate the degrees of leverages.

Income statement

Item	2015	2014
Sales revenue	2,000,000	1,600,000
Cost of goods sold	1,000,000	900,000
Gross profit	1,000,000	700,000
Operating expenses	500,000	400,000
Operating profit (earnings before int. & taxes)	500,000	300,000
interest	100,000	100,000
Net profit before taxes	400,000	200,000
Taxes	80,000	40,000
Net profit after taxes	320,000	160,000
Preferred dividend	10,000	10,000
Earnings available for common shareholders	310,000	150,000
Common dividend	290,000	140,000
Retained Earnings	20,000	10,000

Balance sheet

Item	2015	2014	Item	2015	2014
Current Assets			Liabilities
Cash	220,000	200,000	Current liabilities	200,000	180,000
Account receivable	100,000	80,000	Long-term debts	800,000	800,000
Inventory	400,000	400,000	Total liabilities	1,000,000	980,000
total current assets	720,000	680,000	Shareholders Equity
Fixed assets			Preferred stock (10,000 shares)	20,000	20,000
Total fixed assets	1,000,000	1,000,000	Common stock (20,000 shares)	60,000	60,000
			Accumulated retained earnings	640,000	620,000
Total assets	1,720,000	1,680,000	Total stockholders equity	1,720,000	1,680,000

DOL =   (precise to two decimal points, e.g., 3.45.)

DFL =   (precise to two decimal points, e.g., 3.45.)

DTL =   (precise to two decimal points, e.g., 3.45.)

Answer 1

% Change in EBIT = (Operating Profit, 2015 - Operating Profit, 2014) / Operating Profit, 2014
% Change in EBIT = ($500,000 - $300,000) / $300,000
% Change in EBIT = 0.66667

% Change in Sales = (Sales Revenue, 2015 - Sales Revenue, 2014) / Sales Revenue, 2014
% Change in Sales = ($2,000,000 - $1,600,000) / $1,600,000
% Change in Sales = 0.25

Degree of Operating Leverage = % Change in EBIT / % Change in Sales
Degree of Operating Leverage = 0.66667 / 0.25
Degree of Operating Leverage = 2.67

% Change in EPS = (Earnings available for Common Shareholders, 2015 - Earnings available for Common Shareholders, 2014) / Earnings available for Common Shareholders, 2014
% Change in EPS = ($310,000 - $150,000) / $150,000
% Change in EPS = 1.06667

Degree of Financial Leverage = % Change in EPS / % Change in EBIT
Degree of Financial Leverage = 1.06667 / 0.66667
Degree of Financial Leverage = 1.60

Degree of Total Leverage = % Change in EPS / % Change in Sales
Degree of Total Leverage = 1.06667 / 0.25
Degree of Total Leverage = 4.27