ELAINE KRYSTA S.

PONDO, MBA
Subject Instructor
 CHAPTER 2:
EVALUATING OPERATING AND
FINANCIAL PERFORMANCE OF A
BUSINESS ENTITY

Lesson

2
 Lesson 1:
TOOLS AND TECHNIQUES IN FINANCIAL STATEMENTS ANALYSIS

Learning Objective

After studying Lesson 1, you should be able to:

Define financial statements analysis.

Reconstruct balance sheets and income statements through financial ratios.
Analyze and interpret trend ratios.
Evaluate the past performance of a company through financial ratios.
Interpret the changes in the financial structure of a company.

FINANCIAL STATEMENT ANALYSIS is the process of extracting information from financial statements to
better understand a company’s current and future performance and financial condition.

TOOLS AND TECHNIQUES IN FINANCIAL ANALYSIS

1. Horizontal Analysis
This analysis is used to evaluate the trend in the accounts over the years. It is usually
shown in comparative financial statements.

a. Comparative Statements. The financial data of a company for two specific years
are compared to show the increase or decrease in the account balances along
with their corresponding percentages.

b. Trend ratio. The present financial ratio of a company is compared with its past and
expected future ratios to determine whether or not the company’s financial
condition is improving or deteriorating over time.

2. Vertical Analysis
This analysis uses a significant item in the financial statements as a base value, and all
other items in the financial statements are compared with it.

a. Common-size statements. Each account in the financial statements is expressed

by dividing them to a common base account (total asset, liabilities and equity,
and sales or net sales)

b. Financial ratios. They are classified into five groups

 Liquidity ratios – these ratios gives an idea of the firm’s ability to pay off debts
that are maturing within a year or within the next operating cycle. Satisfactory,
liquidity ratios are necessary if the firm is to continue operating.

 Activity or asset management ratios – these ratios gives an idea of how

efficiently the firm is using its assets. Good asset management ratios are
necessary for the firm to keep its costs low and thus, its net income high.

 Leverage (solvency) ratios – these ratios tells how the firm has financed its
assets as well as the firm’s ability to repay its long- term debt. It also indicate
how risky the firm is and how much of its operating income must be paid to
bondholders rather than stockholders.

 Profitability ratios – these ratios gives an idea of how profitability the firm is
operating and utilizing its assets. It combine the asset and debt management
categories and how their effects on return on equity.
  Market value ratios – these ratios which consider the stock prices gives an idea
of what investors think about the firm and its future prospects. Market book
ratios tell us what investors think about the company and its prospects.

HORIZONTAL ANALYSIS

A. Comparative Statement
The comparative statements are used to evaluate the changes or behavioural
patterns of different accounts in financial statements for two or more years. For the purpose
of comparison, the earlier years serves as the base year.

= Later year – Base year x 100%

Base year
= percentage increase or decrease of an account

B. Trend Ratios
With this method, a company has to choose a specific year of its activities as the base
year. Inviduals accounts in the financial statements of the base year are assigned an index
of 100.

The computation for the year after the base year would be:

Year 1 x 100%
Base year

The computation for two years after the base year would be:

Year 2 x 100%
Base year

VERTICAL ANALYSIS

A. Common-size Statement
In performing a common-size analysis for a balance sheet, the total assets are
assigned as the base account with a percentage of 100. An individual asset account is
expressed as a percentage of total assets. Likewise, the total liabilities and stockholders’
equity is 100%.

In the income statement, net sales are given the value of 100%, and all other
accounts are evaluated in comparison to the net sales.

B. Financial Ratios
The principle idea in analyzing the financial ratios is that there are several major
financial ratios obtainable from the financial statement of a company that reveal its financial
health.

Summary of ratios, formula and significance:

 LIQUIDITY RATIOS

a. Current Ratio Total Current Assets = times

Total Current Liabilities

Current ratio is widely regarded as a measure of short-term debt-paying.

 b. Acid test or Quick Ratio Total Quick Assets* = times
Total Current Liabilities

*Quick Assets = Accounts Receivable + Cash + Marketable Securities

The acid-test (quick) ratio is more rigorous test of a company’s ability to meet its short-term
debts. To properly protected, each peso of liabilities should be backed by at least Php 1 of quick
assets.

c. Working Capital Current Assets less Current Liabilities = Php

Working capital, also known as net working capital (NWC), is the difference between a
company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and
inventories of raw materials and finished goods, and its current liabilities, such as accounts
payable.

 ACTIVITY RATIOS

a. Cash Position Cash + Marketable Securities = times

Current Liabilities

The cash position ratio is a step closer to pure liquidity by removing the account receivable
from the quick ratio.

b. Accounts Receivable Net Sales = times

Turnover Average Accounts Receivable

* Average AR = AR 2024 + AR 2023 / 2

The accounts receivable turnover roughly measures how many times a company’s accounts
receivable have been turned into cash during the year.

c. Average Collection Period 360 = days

Accounts Receivable Turnover

The average collection period helps evaluate the liquidity of accounts receivable and the
firm’s credit policies.

d. Inventory Turnover Cost of Goods Sold = times

Average Inventory

* Average Inventory = Inventory 2024 + Inventory 2023 / 2

The inventory turnover measures the efficiency of the firm in managing and selling inventory.
Generally, a high turnover is preferred because it is a sign of efficient inventory management
and profit for the firm. A relatively low turnover could mean that the company is carrying too
much inventory or it has obsolete, slow-moving or inferior inventory stock.

e. Average Sale Period 360 = days

Inventory Turnover

The number of days being taken to sell the entire inventory one time (called the average
sale or conversion period). Generally, the faster inventory sells, the fewer funds are tied up in
inventory and more profits are generated.
 f. Working Capital Net Sales = times
Turnover Average Working Capital

* Average WC = Working Capital 2024 + Working Capital 2023 / 2

Working capital turnover is a ratio that measures how efficiently a company is using its
working capital to support sales and growth. Also known as net sales to working capital, working
capital turnover measures the relationship between the funds used to finance a company's
operations and the revenues a company generates to continue operations and turn a profit.

g. Total Assets Turnover Net Sales = times

Average Total Assets

* Average Total Assets = Total Assets 2024 + Total Assets 2023 / 2

The total asset turnover is a measure of the efficiency of management to generate sales and
thus earn more profit for the firm. When the asset turnover ratios are low relative to the industry
or the firm’s historical record, it could mean that either the investment in assets is too heavy or
sales are sluggish.

h. Fixed Assets Turnover Net Sales = times

Average Fixed Assets

* Average Fixed Assets = Fixed Assets 2024 + Fixed Assets 2023 / 2

The fixed asset turnover is another approach to assessing management’s effectiveness in

generating sales from investments in fixed asserts particularly for a capital-intensive firm.

 LEVERAGE RATIOS

a. Debt Ratio Total Liabilities = %

Total Assets

The debt ratio measures the proportion of all assets that are financed with debt. Generally,
the higher the proportion of debt, the greater the risk because creditors must be satisfied before
the owners in the event of bankruptcy.

b. Equity Ratio Total Equity = %

Total Assets

The equity ratio simply expresses the percentage of assets financed by equity funds.

c. Debt to Equity Ratio Total Liabilities = %

Total Equity

The debt to equity ratio measures the riskiness of the firm’s capital structure in terms of
relationships between the funds supplied by creditors (debt) and investors (equity).

d. Times interest earned Operating Profit = times

Interest Expense

Times interest earned ratio is the most common measure of the ability of a firm’s operations
to provide protection to long-term creditors. The more times a company can cover its annual
interest expense from operating earnings, the better off will be the firm’s investors.
  PROFITABILITY RATIOS

a. Gross Profit Margin Gross Profit = %

Net Sales

Gross profit margin which shows the relationship between sales and the cost of products sold,
measures the ability of a company to control costs and inventories or manufacturing of products
and to pass along price increases through sales to customers.

b. Operating Profit Margin Operating Profit = %

Net Sales

The operating profit margin is a measure of overall operating efficiency and incorporates all
of the expenses associated with ordinary or normal business activities.

c. Net Profit Margin Net Profit = %

Net Sales

Net profit margin measures the profitability after considering all revenues and expenses,
including, interest, taxes and non-operating items such as extraordinary items, cumulative effect
of accounting change, etc.

d. Rate of return Net Income = %

on Assets (ROA) Average Total Assets

* Average Total Assets = Total Assets 2024 + Total Assets 2023 / 2

e. Rate of return Net Income = %

on Equity (ROE) Average Total Equity

* Average Total Equity = Total Equity 2024 + Total Equity 2023 / 2

Return on assets and return on equity are two ratios that measure the overall efficiency of
the firm in managing its total investment in assets and in generating return to shareholders. These
ratios indicate the amount of profit earned relative to the level of investment in total assets and
investment of common shareholders.

 MARKET VALUE RATIOS

a. Earnings per Share Net Income = Php __ per share

Average Ordinary Shares

* Average Ordinary Shares = Ordinary Shares 2024 + Ordinary Shares 2023 / 2

EPS indicates how much money a company makes for each share of its stock and is a widely
used metric for estimating corporate value. A higher EPS indicates greater value because
investors will pay more for a company's shares if they think the company has higher profits relative
to its share price.

b. Price/ Earnings Ratio Market Price per share = times

Earnings Per Share

The P/E ratio relates earnings per ordinary share to the market price at which the stock trades,
expressing the “multiple” which the stock market places on a firm’s earnings.
 c. Book Value Ordinary Shares = Php__ per share
per share No. of Outstanding Ordinary Shares

Book value per share (BVPS) is the ratio of equity available to common shareholders divided
by the number of outstanding shares.

d. Market-to-Book Value Market Price per share = times

Book Value per share

It is the value of the company’s security as perceived by the market in relation to the value of
the company. A high market-to-book value ratio means investors are more optimistic about the
market value of the company’s resources, capabilities by its top management, and its expected
growth.
e. Dividend Payout Dividends per share = %
Earnings per Share

The dividend payout ratio shows how much of a company’s earnings after tax (EAT) are paid to
shareholders. Dividend payments signal that a business is earning enough to share a portion of its
gains with its owners, encouraging shareholder confidence in the management team.

f. Dividend Yield Dividend per Share = %

Market Price per Share

The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows
how much a company pays out in dividends each year relative to its stock price.
Illustrative Case #1: Comparative Statement of Financial Position of AVS CORPORATION for years
2022 – 2024

AVS CORPORATION
Comparative Statement of Financial Position
December 31, 2024, 2023 and 2022

2024 2023 2022

ASSETS
Current Assets
Cash P 65,000 P 70,000 P 75,000
Accounts Receivable 40,000 35,000 20,000
Marketable Securities 40,000 35,000 10,000
Inventory 100,000 80,000 100,000
Total Current Assets P 245,000 P 220,000 P 205,000
Non-Current Assets 200,000 160,000 170,000

TOTAL ASSETS P 445,000 P 380,000 P 375,000

LIABILITIES
Current Liabilities P 110,000 P 105,000 P 104,000
Non-Current Liabilities 160,000 145,000 140,000
Total Liabilities P 270,800 P 250,000 P 244,000

STOCKHOLDERS’ EQUITY
Common Stock,
Php 5 par value, 20,000 shares P 100,000 P 100,000 P 100,000
Retained Earnings 74,200 30,000 31,000
Total Stockholders’ Equity P 174,200 P 130,000 P 131,000

TOTAL LIABILITIES AND

STOCKHOLDERS’ EQUITY P 445,000 P 380,000 P 375,000

Illustrative Case #2: Comparative Income Statement of AVS CORPORATION for years 2022 – 2024

AVS CORPORATION
Comparative Income Statement
December 31, 2024, 2023 and 2022

2024 2023 2022

Sales P 200,000 P 210,000 P 100,000

Sales returns and allowances 40,000 25,000 6,000
Net Sales 160,000 185,000 94,000
Cost of Goods Sold 100,000 115,625 50,000
Gross Profit P 60,000 P 69,375 P 44,000
Operating Expenses
Selling Expenses 22,000 25,000 16,000
General Expenses 8,000 12,000 8,000
Total Operating Expenses P 30,000 P 37,000 P 24,000
Income from Operations 30,000 32,375 20,000
Non-Operating Income 6,000 2,500 3,500
Income before Interest Expense
and Taxes P 36,000 P 34,875 P 23,500
Interest Expense 4,000 3,500 3,000
Income before Taxes 32,000 31,375 20,500
Income Taxes (35% rate) 11,200 10,981 7,175
Net Income P 20,800 P 20,394 P 13,325
 R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. Financial ratio analysis is conducted by three main group of analysts: credit

analysts, stock analyst and managers. What is the primary emphasis of each
group, and how would that emphasis affects the ratios they focus on?

2. Explain in general terms the concept of return on investment. Why is this

concept important in the analysis of financial performance?

3. Explain the concept of liquidity and why is it crucial to company survival.

 Lesson 2:
OPERATING AND FINANCIAL LEVERAGE

Learning Objectives

After studying Lesson 2, you should be able to:

Understand the concept and application of leverage in business.

Comprehend the assumptions and limitations of the CVP analysis.
Explain the meaning and nature of operating leverage and financial leverage.
Calculate and interpret the firm’s degree of operating leverage and financial leverage.
Explain the impact of combining operating leverage and financial leverage.

Leverage represents the use of fixed costs items to magnify the firm's results. It is however, important
to keep in mind that leverage is a two-edged sword producing highly favorable results when things
go well, and quite the opposite under negative conditions.

LEVERAGE IN A BUSINESS

Assume that there exists an opportunity to start your own business. You are to manufacture
and market industrial parts, such as ball bearings, wheels and casters. You are faced with two
primary decisions.

First, you must determine the amount of fixed cost plant and equipment you wish to use in
the production process. By installing modern, sophisticated equipment, you can virtually eliminate
labor in the production of inventory. At high volume, you will do quite well, as most of your costs are
fixed payments for plant and equipment. If you decide to use expensive labor rather than
machinery, you will lessen your opportunity for profit, but at the same time, you will lower your
exposure to risk (you can lay off part of the workforce).

Second, you must determine how you will finance the business. If you rely on debt financing
and the business is successful, you will generate substantial profits as an owner, paying only the fixed
costs of debt. Of course, if the business starts off poorly, the contractual obligations related to debt
could mean bankruptcy. As an alternative, you might decide to sell equity rather than borrow a step
that will lower your own profit potential but minimize your risk exposure.

In both decisions, you are making very explicit decisions about the use of leverage. To the
extent that you go with a heavy commitment to fixed costs in the operation of the firm, you are
employing operating leverage. To the extent that you utilize debt in the financing of the firm, you
are engaging in financial leverage.

CVP ANALYSIS

Cost-volume-profit (CVP) analysis is a powerful tool and vital in many business decisions
because it helps managers understand the relationships among cost, volume and profit. CVP
analysis focused on how profits are affected by the following elements (a) selling prices, (b) sales
volume, (c) unit variable costs, (d) total fixed costs, and (e) mix of products sold.

This model is used to answer a variety of critical questions such as:

 What is the company's breakeven volume?

 What is its margin of safety?
 What is likely to happen if specific changes are made in prices, costs and volume?
 Financial managers need to know the costs that are likely to be incurred under normal
operating conditions and how they might vary if conditions change. They need to understand which
costs would stay the same and which costs would follow the movement of volume and so on.

If the above items are known, the following relationships may be established:

Contribution Margin per unit or marginal income per unit

This is the excess of unit selling price over unit variable costs and the amount
each unit sold contributes toward:
1. covering fixed costs and
2. providing operating profits.

Formula:
CM per unit = Unit selling price – Unit variable costs

Contribution Margin ratio

This is the percentage of contribution margin to total sales. This ratio is

computed as follows:

CM ratio = Contribution Margin

Sales

The CM ratio is very useful in that it shows how the contribution margin will be
affected by a given peso change in total sales. For instance, if a company's CM ratio
is 40%, it means that for each peso increase in sales, total contribution margin will
increase by P0.40. Net income likewise will increase by P0.40 assuming that there are
no changes in fixed costs.

The CM ratio is particularly valuable in those situations where the manager

must make trade-offs between change in selling price and change in variable costs.

CVP ANALYSIS FOR BREAKEVEN PLANNING

The starting point in many business plans is to determine the break-even point.

Break-even point is the level of sales volume where total revenues and total expenses are
equal, that is, there is neither profit or loss. This point can be determined by using CVP analysis. Break-
even point can be computed as follows:

1. Break-even point (units) = Total Fixed Costs_______

Contribution Margin per unit

2. Break-even point (pesos) = Total Fixed Costs_______

1– Variable Costs
Sales

3.
a. Break-even sales = Total Fixed Costs_______
for multi-products Weighted Average
firm (combined units) Contribution Margin

b. Weighted Contribution
Margin per unit =

Unit CM x No. of units

per Mix + Unit Cm x No. of units
per Mix________
Total number of units per Sales Mix
 4.
a. Break-even sales for
multi-products firm = Total Fixed Costs________
(combined pesos) Weighted CM ratio

b. Weighted CM ratio = Total Weighted CM (Php)________

Total Weighted Sales (Php)

CVP ANALYSIS FOR REVENUE AND COST PLANNING

CVP analysis can be used to determine the level of sales needed to achieve a desired level
of profit. In revenue planning, CVP analysis assists managers in determining the revenue required to
achieve a desired profit level. The equation that may be used to compute for target sales follows:

Sales = Total Fixed Costs + Desired Profit

Contribution Margin per unit

or

Sales = Total Fixed Costs + Desired Profit

Contribution Margin Ratio

SALES MIX

Sales mix refers to the relative proportions in which a company's products are sold. The idea
is to achieve the combination, or mix that will yield the greatest amount of profits. Most companies
have many products, and often these products are not equally profitable. Hence, profits will depend
to some extent on the company's sales mix. Profits will be greater if high-margin rather than low-
margin items make up a relatively large proportion of total sales.

Changes in the sales mix can cause perplexing variations in a company's profits. A shift in the
sales mix from high-margin items to low-margin items can cause total profits to decrease even
though total sales may increase. Conversely, a shift in the sales mix from low-margin items to high-
margin items can cause the reverse effect; total profits may increase even though total sales
decrease. It is one thing to achieve a particular sales volume, it is quite another to sell the most
profitable mix of products.

Illustrative Case #3. CVP Analysis for a Multi-Products Firm

Taylor, Inc. produces only two products, A and B. These account for 60% and 40% of the total
sales pesos of Taylor's respectively. Variable costs as a percentage of sales pesos are 60% for A and
85% for B. Total fixed costs are P150,000. There are no other costs.

Required:

1. Compute the weighted contribution margin ratio.

2. Compute the break-even point in sales pesos.

3. Compute the sales pesos necessary to generate a net income of P9,000 if total fixed costs
will increase by 30%.

OPERATING LEVERAGE

Operating leverage is a measure of how sensitive net operating income is to a given

percentage change in peso sales. Operating leverage acts as a multiplier. If operating leverage is
high, a small percentage increase in sales can produce a much larger percentage increase in net
operating income.

Operating leverage can be illustrated with use of the following data for two mango farms,
Green Farm and Yellow Farm.

Green Farm Yellow Farm

Present Expected Present Expected

Sales P 100,000 P 110,000 P 100,000 P 110,000

Variable Expenses 60,000 66,000 30,000 33,000
Contribution Margin 40,000 44,000 70,000 77,000
Fixed Expenses 30,000 30,000 60,000 60,000
Net Operating Income P 10,000 P 14,000 P 10,000 P 17,000

DEGREE OF OPERATING LEVERAGE

The degree of operating leverage at a given level of sales is computed by the following
formula:

Degree of operating leverage = ___Contribution Margin___

Net Operating Income

The degree of operating leverage is a measure, at a given level of sales, of how a percentage
change in sales volume will affect profits. To illustrate, the degree of operating leverage for the two
farms at P100,000 sales would be computed as follows:

Green Farm P 40,000 = 4

P 10,000

Yellow Farm P 70,000 = 7

P 10,000

Because the degree of operating leverage for Green Farm is 4, the farm's net operating
income grows four times as fast as its sales. In contrast, Yellow Farm's net operating income grows
seven times as fast as its sales. Thus, if sales increase by 10%, then we can expect the net operating
income of Green Farm to increase by four times this amount, or by 40% and the net operating income
of Yellow Farm to increase by seven times this amount or by 70%.

Percent Increase Degree of Percent Increase

in Sales Operating in Net Operating
Leverage Income

(1) (2) (1) x (2)

Green Farm 10% 4 40%

Yellow Farm 10% 7 70%

What is responsible for the higher operating leverage at Yellow Farm? The only difference
between the two farms is their cost structure. If two companies have the same total revenue and
same total expense but different cost structures, then the company with the higher proportion of
fixed costs in its costs structure will have higher operating leverage.
Alternative Approach

Degree of Operating Leverage (DOL) is also viewed as the percentage change in operating
income that occurs as a result of a percentage change in units sold.

Degree of Operating Leverage = Percent change in operating income

Percent change in unit volume

Illustrative Case #4. Operating Leverage/CVP Relationship

Voltex Company manufactures and sells a specialized cordless telephone for high
electromagnetic radiation environments. The company's contribution format income statement for
the most recent year is given below:

Total Per Unit Percent of Sales

Sales (20,000 units) P 1,200,000 P 60 100%

Variable expenses 900,000 45 ?
Contribution margin 300,000 15 ?
Fixed expenses 240,000
Net operating income P 60,000

Management is anxious to increase the company's profit and has asked for an analysis of a
number of items.

Required:

1. Compute the company's CM ratio and variable expense ratio.

2. Compute the company's break-even point in both units and sales pesos. Use the equation
method.

3. Assume that sales increase by P400,000 next year. If cost behavior patterns remain unchanged,
by how much will the company's net operating income increase? Use the CM ratio to compute
the answer.

4. Refer to the original data. Assume that next year management wants the company to earn a
profit of at least P90,000. How many units will have to be sold to meet this target profit?

5. Refer to the original data. Compute the company's margin of safety in both peso and
percentage form.

6.

a. Compute the company's degree of operating leverage at the present level of sales.

b. Assume that through a more intense effort by the sales staff, the company's sales increase
by 8% next year. By what percentage would you expect net operating income to
increase? Use the degree of operating leverage to obtain your answer.

c. Verify your answer to (b) by preparing a new contribution format income statement
showing an 8% increase in sales.
7. In an effort to increase sales and profits, management is considering the use of a higher-quality
speaker. The higher-quality speaker would increase variable costs by P3 per unit, but
management could eliminate one quality inspector who is paid a salary of P30,000 per year. The
sales manager estimates that the higher-quality speaker would increase annual sales by at least
20%.

a. Assuming that changes are made as described above, prepare a projected contribution
format income statement for next year. Show data on a total, per unit, and percentage
basis.
b. Compute the company's new break-even point in both units and pesos of sales. Use the
formula method.

c. Would you recommend that the changes be made?

FINANCIAL LEVERAGE

Financial leverage reflects the amount of debt used in the capital structure of the firm.
Because debt carries a fixed obligation of interest payments, we have the opportunity to greatly
magnify our results at various levels of operations.

It is helpful to think of operating leverage as primarily affecting the left-hand side of the
statement of financial position and financial leverage as affecting the right-hand side.

Statement of Financial Position

Assets Liabilities and Owners’ Equity

Operating Leverage Financial Leverage

Whereas operating leverage influences the mix of plant and equipment, financial leverage
determines how the operation is to be financed. It is possible for two firms to have equal operating
capabilities and yet show widely different results because of the use of financial leverage.

IMPACT ON EARNINGS

In studying the impact of financial leverage, we shall examine two financial plans for a firm,
each employing a significantly different amount of debt in the capital structure. Financing totaling
P200,000 is required to carry the assets of the firm.

Total Assets – P 200,000

Plan A Plan B
(Leveraged) (Conservative)

Debt (8%
interest) P 150,000 (P 12,000 interest) P 50,000 (P 4,000 interest)
Common (8,000 shares at (24,000 shares at
Stock 50,000 P 6.25) 150,000 P 6.25)
Total P 200,000 P 200,000
Financing

Under leveraged Plan A, we will borrow P1 50,000 and sell 8,000 shares of stock at P6.25 to
raise an additional P50,000, whereas conservative Plan B calls for borrowing only P50,000 and
acquiring an additional P1 50,000 in stock with 24,000 shares.
 Figure 2-1. Computation of Earnings Per Share (EPS)

EBIT EBIT EBIT EBIT EBIT

P0 P 12,000 P 16,000 P 30,000 P 50,000

Plan A Plan B Plan A Plan B Plan A Plan B Plan A Plan B Plan A Plan B

Earnings
Before
Interest
and Taxes
(EBIT) P 0 P 0 P 12,000 P 12,000 P 16,000 P 16,000 P 30,000 P 30,000 P 50,000 P 50,000
Less:
Interest 12,000 4,000 12,000 4,000 12,000 4,000 12,000 4,000 12,000 4,000
Earnings
Before
Taxes
(EBT) (12,000) (4,000) 0 8,000 4,000 12,000 18,000 26,000 38,000 46,000
Less:
Taxes (50%) (6,000) (2,000) 0 4,000 2,000 6,000 9,000 13,000 19,000 23,000
Earnings
After
Taxes (EAT) (6,000) (2,000) 0 P 4,000 P 2,000 P 6,000 P 9,000 P 13,000 P 19,000 P 23,000
Shares 8,000 24,000 8,000 24,000 8,000 24,000 8,000 24,000 8,000 24,000
Earnings
Per Share
(EPS) P (0.75) P (.08) P 0 P 0.17 P .25 P .25 P 1.13 P .54 P 2.38 P .96

*Plan A – Leveraged
*Plan B – Conservative
DEGREE OF FINANCIAL LEVERAGE

The degree of financial leverage measures the effect of a change in one variable to another
variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings
(EPS) that occurs as a result of a percentage change in earnings before interest and taxes (EBIT).

Degree of financial leverage = Percent change in EPS

Percent change in EBIT

For purposes of computation, the formula for DFL may be conveniently restated as:

Degree of financial leverage = _____EBIT_____

EBIT - 1

Let's compute the degree of financial leverage for Plan A and Plan B at an EBIT level of P 36,000. Plan
A calls for P 12,000 of interest at all levels of financing, and Plan B requires P4,000.

Plan A (Leveraged)

DFL = _____EBIT_____ = P 36,000______ = P 36,000 = 1.5

EBIT - 1 P 36,000 – P 12,000 P 24,000

Plan B (Conservative)

DFL = _____EBIT_____ = P 36,000______ = P 36,000 = 1.1

EBIT - 1 P 36,000 – P 4,000 P 32,000

COMBINING OPERATING AND FINANCIAL LEVERAGE

Degree of combined leverage (DCL) use the entire income statement shows the impact of a
change in sales or volume on bottom-line earnings per share. Degree of operating and financial
leverage is in effect, being combined.

Figure 2-2 shows what happens to profitability as the firm's sales go from P160.000 (80,000
units) to P200,000 (100,000 units)

Sales (P 2 per unit x 80,000 units) P 160,000 P 200,000

Less: Fixed costs 60,000 60,000
Variable costs 64,000 80,000
Operating Income (EBIT) 36,000 60,000
Less: Interest 12,000 12,000
Earnings before taxes 24,000 48,000
Less: Taxes 12,000 24,000
Earnings after taxes P 12,000 P 24,000
Shares 8,000 8,000
Earnings per share P 1.50 P 3.00

Figure 2-2. Combining Operating and Financial Leverage

The formula for degree of combined leverage is stated as:

Degree of combined leverage (DCL) = ___Percent change in EPS___

Percent change in Sales
(or volume)
Using data from Figure 2-2, the degree of combined leverage is:

__P 1.50__
x 100
Percent change in EPS__ = P 1.50 = __100%__ = 4
Percent change in Sales P 40,000_ x 100 25%
P 160,000

Every percentage point change in sales will be reflected in a 4 percent change in earnings per
share at this level of operation.

The formula is:

Degree of combined leverage (DCL) = _______Q(P – VC)_________

Q(P – VC) – FC – 1

From Figure 2-2, Q (quantity) = 80,000; P (price per unit) = P 2.00; VC (variable costs per unit) =
P 0.80; FC (fixed costs) = P 60,000; and 1 (interest) = P 12,000

DCL = ___________80,000 (P 2,000 – P 0.80)____________

80,000 (P 2,000 – P 0.80) – P 60,000 – 12,000

= ___________80,000 (P 1.20)_____
80,000 (P 1.20) – P 72,000

= __________P96,000______
P 96,000 – P 72,000

DCL = __P 96,000__

P 24,000

= 4
 R E V I E W Q U E S T I O N S

Direction: Answer comprehensively the following questions.

1. What is meant by a product’s contribution margin ratio? How is this ratio useful
in planning business operations?

2. What factors would cause a difference in the use of financial leverage for a
utility company and an automobile company?

3. What does risk-taking have to do with the use of operating and financial
leverage?