Business Risk and Financial Risk 207

•
BUSINESS RISK
AND
FINANCIAL RISK

Learning Objectives
After studying this chapter, you should be able to know :
• Concept ofleverage
• Types ofleverages
• Calculation of Various leverages

Synopsis

I. Introduction
2. Meaning of Risk
2.1 Business Risk
2.2 Financial Risk
2.3 Distinction between Business Risk and Financial Risk
3. Debt vis. Equity Financing
4. Types ofl everages
4.1 Operating l everage
4.2 Financial l everage
4.3 Relationship between Operating and Financial leverage
4.4 Composite l everage
5. Exercises
5.1 Conceptual Questions
5.3 Practical Problems
208 Financial Management-Tl (S. YB.B.l.) (Sem. - IV)

1. INTRODUCTION
A business organisation can increase its funds by increasing the claims of owners or creditors
or both. The owner's claims increase when the firm raises funds by issue of equity shares or by
retaining the profits. Creditors' claims increase by borrowings. The mix of these sources is called
Capital Structure or Financial Structure. Capital Structure decisions are very important for
management of a firm. These decisions affect the debt equity of a firm . If the debt is more than
owners' equity, it increases shareholders' return and risk. On the other hand, if debt is less than
owners' equity, it decreases shareholders' return and risk. Therefore, the concept that is used to
stu dy the effects of the various mix of debt and equity o n shareholders' return and risk is called
leverage.
Leverage implies the ability of a firm to use fixed cost assets or funds in order to magnify the
return to its shareholders.
Leverage is also defined as relative change in profits due to change in sales. Fixed costs have to
be paid irrespective of production and sales. Such cost affects the amount of profits available for
shareholders and the leverage helps to measure the effects of change in sales or profits. In other
words, a small increase or decrease in sales can increase or decrease the profits of a firm to a
greater extent. There are two reasons for this. A part of the operating cost is the fixed cost which
does not rise as rapidly as sales increase. Similarly, certain interest payment is fixed. It leads to
increase in the net profit after interest to a greater extent.
i Q. 1. What is leverage?
2. MEANING OF RISK
Risk arises due to lack of certainty. Risk attached to a firm can be divided into two categories
viz. Business risk and financial risk.
2 . I Business Risk
It is the variability of earnings before interest and tax. It arises due to internal and external
environment in which the firm operates. It is an unavoidable risk. It is associated with capital
budgeting decisions. It is measured by calculation of operating leverage. The degree of operating
leverage does not differ due to use of different forms of financing.
2.2 Financial Risk
It is the variability of earnings before tax. It arises due to use of financial leverage. It is an
avoidable risk. The firm can avoid it by using proper financing form. It is associated with capital
structure decisions. It is measured by calculation of financial leverage. The degree of financial
leverage differs with the use of different forms of financing.
2.3 Distinction between Business Risk and Financial Risk
Point Business Risk Financial Risk
1. Concept It is the variability of earnings before It is the variability of earning before
interest and tax. tax.
2. Cause It arises due to internal and external It arises due to use of financial
environment in which the firm has leverage.
to operate.
3. Nature It is an unavoidable risk. It is an avoidable risk.
4. Relevance It is related to Capital budgeting It is related to capital structure
decisions. decisions.
5. Measurement It IS measured by operating It is measured by financial leverage.
leverage.
6. Effect It is not affected by the forms of It is affected by the forms of
financing. financing.
IQ. 2. Write a note on : Financial Risk. (April 2018) I

3. DEBT V/S. EQUITY FINANCING

There are two sources of raising finance i.e. Debt and Equity. Debt includes debentures, Bank
loans, Public deposits etc. It is the borrowed capital. Equity includes equity share capital preference
share capital and reserves and surplus.
Business Risk and Financial Risk 209

Debt
Debt has the following features :
I. It is a loan capital.
2. It has fixed rate of interest.
3. Interest is payable irrespective of profit.
4. Interest on debt has tax advantage to the company.
s. It is refundable after a certain period.
6. Loan creditors have no right of management.
Equity
Equity has the following features :
I. It is risk capital.
2. It is own fund.
3. Rate of dividend is not fixed except preference share capital.
4. Dividend is payable out of profit.
S. Dividend has no tax advantage to the company.
6. Equity capital is not refundable preference share capital is redeemable.
The finance manager has to take a right decision about selection of the source of finance
i.e. debt and equity.
Initially a company may raise capital by issue of equity capital. Once the company is
established and it has sufficient income to pay interest, it may go for debt.
Raising funds by debt benefits the company from taxation point of view. Interest brings down
the taxable income and tax liability. This benefit is not available for equity.
Raising funds by debt requires mortgage of assets of the company. Assets cannot be kept free.
Moreover, debt creates fixed burden on income by way of interest. Raising funds by equity does not
create any charge on assets. Assets are kept free. Companies raise crores of rupees from capital
market by issue of shares and without creating any charge on assets.
Payment of dividend is not obligatory.
The finance manager should consider the about aspects of debt and equity financing and
select such a source which maximises earning per share.
i Q. 3. Write a short note on : Debt vi s. Equity Financing.
''----------------------------------------~
4. TYPES OF LEVERAGES
The increase or decrease in profits occurs on account of fixed operating cost and fixed
financial cost, therefore, there are two types of leverages :
4.1 Operating Leverage
Total cost of a firm consists of two types of costs, i.e., fixed costs and variable costs. Fixed costs
are those costs which are not affected by the change in output and sales, whereas, variable costs
vary in direct proportion to the output and sales. When a firm uses such an asset for which it has to
pay fixed costs, it is said that operating leverage exists in the firm. The extent of fixed costs in
operating activities of a firm decides the operating leverage. If the fixed operating cost is more than
variable operating costs, the operating leverage will be higher and vice-versa.
Operating leverage is, thus, the sensitivity of operating profits to changes in sales. For example,
if the sales increases by 30% and the operating profit increases by 110%, it is a case of high
operating leverage. If there are no fixed costs, there will be no operating leverage and the rate of
change in operating profits will be equal to the rate of change in sales.
Thus, the operating leverage is the use of fixed costs to magnify a change in profits relative to a
given change in sales.

IQ. 4. Write a short note on : Operating Leverage.

Illustration : 1
Jigna Ltd. sells 1,00,000 units of a product. Selling price is ~ IO per un it and variable cost is ~ 3. If the
fixed cost for the year amounts to ~ 4,00,000, find out the effect on profit, if the company sells I , 10,000 units
and 80,000 units.
2/0 Financial Management-Tl (S. Y B.B.l.) (Sem. - IV)

Solution
Computation of Operating Profit
1,00 ,00 0 Units 1, 10 ,000 Units 80,000 Units
( ( (
Sales 10,00,000 1 1,00,000 8,00,000
Less : Variable Cost
@ ( 3 p er unit 3 ,00,000 3 ,30 ,000 2,40,000
Contribution 7,00,000 7,70,000 5,60,000
Less : Fixed Cost 4,00,000 4,00,000 4,00,000
Operating P rofit 3,00,000 3,70,000 1,60,000
1,00,000 2,00,000
% Change in Sales 10 , 00 , 000 X lOO 10,00,000 X lQO
= + 10% = - 20%
70,000 1,40,000
% Change in Profit 3 ,00 ,000 X 100 3 ,00,000 X lQO
= + 23 .33% = - 46.67%
Conclusions :
The above statement shows that a l 0% increase in sales, increases the profit by 23.33%, w hereas, a 20%
decrease in sales, decreases the profit by 46.67%. It clearly shows that an increase in sales results into more
than proportionate increase in profit and the decrease in sales has the exactly opposite effect. The former is
known as favourable operating leverage and the later is known as unfavourable operating leverage.

4.1.1 Calculation of Operating Leverage

Operating leverage may be calculated on the basis of break-even analysis. Accordingly,
operating leverage is calculated by the following formula :
Contribution
Operating Leverage
Operating Profit
OR
C
EBIT
OR
Sales - Variable Cost
Contribution - Fixed Cost
If the contribution is more than the fixed costs, there is a favourable operating leverage. If fixed
costs are more than contribution, the operating leverage will be unfavourable.

Illustration : 2
Ambika Ltd. sells 2,000 units per annum. The selling price per un it is ( 300 and the variable cost per
unit is ( 70. T he fixed operating cost is ( 60,000.
Calcu late operating leverage.
Solution:
Computation of Ope rating Leve rag e

Sales 2,000 X 300 6 ,00,000

Less : Variable Cost 2,000 X 170 3,40 ,000
Contribution 2 ,60,000
Less : Fixed Cost 60,000
Ope rating Profit (EBIT) 2,00 ,000
Contribution
Operating Leverage
Operating Profit
2,60,000
2,00,000
1.30
4 . 1.2 Degree of Operating Leverage
It is the ratio of the percentage change in operating profits to percentage change in sales.
. Percentage Change in Profit
Degree of Operating Leverage = Percentage Chnage in Sales
Business Risk and Financial Risk ., .,...,.. 211

Illustration : 3
Y Ltd. sells its product at< 20 per unit. Variable cost per un it is < 15. Find out the degree of operating
leverage for sale of 3,000 units and 3,500 units. What do you understand from the degree of operating
leverage at these sales volumes. Fixed cost is< 10,000.
Solution
Computation of Operating Profit
3,000 Units 3,500 Units
t t
Sales @ < 20 per unit 60,000 70,000
Less : Variable Cost @ < 15 45,000 52,500
Contribution 15,000 17,500
Less : Fixed Cost 10,000 10,000
Operating Profit 5.000 7,500
C 15,000 = 17,500
Oper ating Leverage
ESIT 5 ,000
3
7 ,500
= 2.33
10,000
% Change in Sales X 100
60,000
= 16 .67%
% Change in Profit 2,500 X lQO
5 ,000
= 50%
% Change in Profits
Degree of Operating Leverage
% Change in Sales
50%
16.67%
2.99 = i.e. 3
Conclusions
A 16.67% increase in Sales resu lts in 50% increase in profi ts. It shows that increase in profits is more as
compared to increase in sales due to operating leverage. Degree of operating leverage is equal to the
operating leverage of previous level of sales.
4.2 Financial Leverage
It is related to financing activities of the firm. Financial leverage arises when a firm raises
finance by the securities which involve fixed rate of return. The securities which are having fixed
return are debentures and preference shares. Interest on debt is fixed and it has to be paid
irrespective of earnings. The rate of dividend on preference share capital is fixed. It is paid when the
company earns profits. The rate of dividend on equity shares is not fixed. Earnings after interest, tax
and preference dividend belongs to equity shareholders. When the rate of earnings is higher than
the rate of interest and preference dividend, earning per equity share increases. The effect of fixed
cost securities on the earnings per share is the result of financial leverage.
Financial leverage is the firm's ability to use fixed financial charges or costs to magnify the
effect of changes in earnings, before interest and tax on firm's earnings per share. In simple words,
in financial leverage, effect of changes in earning before interest and tax on firm's earning per share
due to use of fixed interest bearing securities is analysed.
Financial leverage may i.Je favuurni.Jle or unfavuurni.Jle. It is favuurni.Jle when the firm's
earnings by use of fixed interest bearing securities is more than their fixed cost. It is also called as
trading on equity. It is unfavourable when the firm's earnings are less than the cost of debt.
4.2. 1 Effect of Financial Leverage
Financial leverage has two effects :
I. Effect on Shareholders' Earnings
Effect on shareholders' earnings depends on the relationship between earnings before interest
and tax and the amount of interest charges and preference dividend. In other words, it depends on
the extent to which fixed financial charges are covered by the earnings of the firm. Financial
leverage has a favourable effect on earning per share when the rate of earning is higher than the
rate of fixed charges.
If a company earns 15% on the assets financed by debt at 10%, there will be an increase of 5%
in earning per share after payment of interest on debt. On the other hand, if a company earns only
9%, the earning per share will decrease by I%. Thus, financial leverage has the potentiality of
increasing as well as decreasing the earning per share.
212 .,.,., Financial Management-Tl (S. Y B.B.l.) (Sem. - IV)

2. Effect on Financial Risk

Financial risk is the inability of a company to cover fixed financial charges. When a company
fails to pay fixed interest charges year after year, there will be a demand from creditors to wind up
the company. Thus, if there is a larger proportion of debt in capital structure, there will be a greater
financial risk. Hence, it is said that debt is like a fat which is good for a healthy person and
dangerous to a person who is having high blood pressure. Therefore, the company's debt absorbing
and paying capacity must be kept in view.
I Q. 5. Write a short note on Financial Leverage.
4.2.2 Computation of Financial Leverage
At single level of profit, the financial leverage is calculated as follows :
EBIT
i) If there is no preference dividend = EBT
EBIT
ii) If there is preference dividend
Pref-dividend)
EBIT - ( I_ t
Effect of Financial Lev erage on EPS
i) EPS will increase if ROI is more than cost of Debt.
ii) EPS will decrease if ROI is less than the cost of Debt.
In the case of preference share capital, preference dividend should be grossed up as per the
tax rate and then deducted from earnings before interest and tax.
Illustration : 4
Compute financial leverage from the follow ing information :

Inte rest 10,000

Sales (1,000 units) 1,00 ,000
Variable Cost 50,000
Fixed Cost 3 0 ,000
Solution
Computation of Financial Leverage

Sales 1,00 ,000

Less : Variable Cost 50,000
Contribution 50,000
Less : Fixed Cost 3 0 ,000
Ope rating Profit 2 0 ,000
Less : Inter est 10,000
Profit before Tax 10 000
Operating Profit
Financial Leverage
Profit before Tax
20,000
10,000
2
Illustration : 5
Shruti Ltd. has the following capital structure :

Equity Share Capital 5 ,00,000

10% Preference Share Capital 5,00,000
8% D eb entures 5,50 ,000
The present EBIT is ~ 2,50,000. Tax rate is 50%.
Calcu late financ ial leverage.
Solution

Operating Profit 2,50,000

Less : Inter est on Debentures 44 000
Profit before Tax 2 06 000
Business Risk and Financial Risk 213

EBIT
Financial Leverage
EBT
2,50,000
2,06,000
1.21
4.2.3 Degree of Financial Leverage
There are two methods of measuring degree of financial leverage :
a) It can be measured by the percentage change in earning per share in relation to the
percentage change in earnings before interest and tax.
Percentage Change in EPS
Degree of Financial Leverage Percentage Change in EBIT
b) It can be measured by the percentage change in taxable profits as a result of percentage
change in operating profits.
Percentage Change in Taxable Profits
Degree of Financial Leverage Percentage Change in Operating Profits
If the ratio does not exceed one, there will be no financial leverage.
4.2.4 Utility of Financial Leverage
It is useful as follows :
a) Capital structure planning,
b) Profit planning,
c) Increase in shareholders' income.
4 .3 Relationship between Operating and Financial Leverage
There is a close relationship between operating leverage and financial leverage. Operating
leverage is concerned with investment decisions whereas financial leverage is concerned with
financing decisions. The differences between the two leverages are as follows :
Operating Leverage Fina ncial Leverage
1. Objective The objective is to magnify the effect The objective is to magnify the effect of
of changes in sales on operating changes in operating profits on
profit. earnings per share.
2. Relationship It establishes relationship between It establishes relationship b etween
operating profit and sales. operating profits and return on equity.
3. Measurement It measures a firm's ability to use It measures a firm 's ability to use fixed
fixed cost assets to magnify the cost funds to magnify the return to
operating profits. equity share-hold ers.
4. Relationship It relates to the assets side of the It relates to the liability side of the
Balance Sheet. Balance Sheet.
5. Effect on It affects profit before interest and It affects profit after interest and tax.
Income tax.
6. Risk It involves operating risk of being It involves financial risk of being
unable to cover fixed operating cost. unable to cover fixed financial cost.
7. Decision It is concerned with investm ent It is con cerned with financing
decisions. decisions.
8. Stage It is described as first stage leverage. It is d escribe d as second stage leverage.

IQ. 6. D istinguish between Operating and Financial Leverage.

4 .4 Composite Lev erage

Operating leverage and financial leverage are combined to assess the impact of all types of
fixed costs. It is, thus, the relationship between contribution and taxable income.
Combined Leverage Operating Leverage x Financial Leverage
OR
Contribution EBIT
X
EBIT EBT
OR
Contribution
EBT
2/4 Financial Management-Tl (S. Y B.B.l.) (Sem. - IV)

Statements of EBIT - EPS Statement

Sales xx
Less Variable cost xx
Contribution xx
Less Fixed Cost xx
EBIT xx
Less Interest xx
EBT xx
Less Tax xx
EAT xx
Less Preference Dividend xx
Earning available for Equity shareholders xx
No of equity shares xx
E to E.S.H
EPS No of equity shares xx
Price Earning Ratio (P/E) xx
Market price (EPS x PE Ratio) xx
Contribution
Operating leverage = EBIT
Financial leverage :
EBIT
a) If No of divided
EBT
EBIT
b) If pref. divided
Pref. dividened)
EBT- ( I_t

Combined leverage = Operating leverage x Financial leverage

Calculation of sales level at which EBIT /EBT / EPS will be Zero
Fixed cost
a) Sales level at which EBIT will be Zero = p /V ratio

. . Fixed cost interest

b) Sales level at which EBT will be zero = p /V Ratio

(Pref.dividen ed)
Fixed cost + Interest + I _t
c) Sales level at which EPS will be Zero = p /V Ratio

Illustration : 6
Y Ltd. has sales of< 2,00,000. Variable cost is 50% of sales while the fixed operating cost amounts to
< 60,000. Interest on long-term loan amounted to < 20,000.
You are requested to calculate the composite leverage and analysis the impact if sales increase by 10%.
Solution
Calculation of Composite Leverage

Sales 2 ,00,000
Less : Variable Cost (50% ) 1,00,000
Contribution 1,00,000
Less : Fixed Ope rating Cost 60,000
EBIT 40,000
Less : Interest 20,000
EBT 2.Q.Q.Q.Q
Contribution
Composite Leverage
EBT
1,00,000 =
5
20,000
The combined leverage shows that I% increase in sales w ill result in 5% increase in profit before tax.
This can be verified w ith 10% increase in sales.

Sales (2 ,00,000 + 10 % ) 2 ,20 ,000

Less : Variable Cost 1,10,000
Contribution 1 , 10,000
Less : Fixed Operating Cost 60,000
Business Risk and Financial Risk 215

EBIT 50,000
Less : Interest 2 0 ,000
EBT ~
Increase in Profit
% Increase in Profit X 100
Base Profit
10,000 100
20,000 X

50%
From the above, it becomes clear that 10% increase in sales has resulted in 50% increase in profit before
tax.
Illustration : 7
The following information is avai lable in respect of two firms, P Ltd. and Q Ltd.:
(Figures in <Lakhs)
p ~td. I Q ~td.

Sales 500 1,000

- Variable Cost 200 300
Contribution 300 700
- Fixed Cost 150 400
EBIT 150 300
- Interest 50 100
Profit before Tax 1QQ 200
You a re required to calculate diffe rent leverages for both the fim1s and also comment on the ir relative
risk position.
Solution
Calculation of different Leverages (P Ltd.) :
Contribution
Operating Leverage
EBIT
<300 lakhs
< 150 lakhs
2
EBIT
Financial Leverage
Profit before Tax
<150 lakhs
< 100 lakhs
1.5
Contribution
Combined Leverage
Profit before Tax
Operating Leverage x Financial Leverage
2 X 1.5
3
Calculation of different Leverages (Q Ltd.) :
Contribution
Operating Leverage
EB IT
<700 lakhs
<300 lakhs
2.33
EB IT
Financial Leverage
Profit before Tax
<300 lakhs
<200 lakhs
1.5
Contribution
Combined Leverage
Profit before Tax
Operating Leverage x Financial Leverage
2.33 X 1.5
3.5
2/6 Financial Management-Tl (S. Y B.B.l.) (Sem. - IV)

The operating leverage is higher in case of Q Ltd . and hence, it has greater degree of operating or
business risk. However, both the com pan ies have same degree of financial leverage. Hence, both the firms
have same financial risk. Combined leverage of Q Ltd. is higher. P Ltd. has lower risk.
Illustration : 8
A simplified Income Statement of Zenith Ltd. is g iven below. Calculate its degree of operating leverage,
degree of financial leverage and degree of combined leverage.
Zenith Ltd. - Income Statement
for the year ending 31 st March, 2017

Sales 10,50,000
Variable Cost 7,67,000
Fixed Cost 75,000
EBIT 2,08,000
Interest 1, 10,000
Taxes (30% ) 29,400
Net Income 68,600
Solution
Contribution
1. Operating Leverage
Earn ings Before Interest and Tax (EBIT)
Contribution Sales - Variable Cost
< <
10,50,000 - 7 ,67 ,000
< 2,83,000
EBIT Sales - Variable Cost - Fixed Cost
< 10,50,000 - <7,67,000 - <75,000
< 2,08,000

Operating Leverage
< 2,83,000
<2,08,000
1.36
Earn ings Before Interest and Tax
2. Financial Leverage
Earnings Before Tax
Earnings Before Tax Net Income + Tax
< <
68,600 + 29,400
< 98,000

Financial Leverage
< 2,08,000
< 98,000
2.12
3. Combined Leverage Operating Leverage x Financial Leverage
J.36 X 2.] 2
2.88
Illustration : 9
1. Find out Operating Leverage from the fo llowing data :
Sales <50,000
Variable Costs 60%
Fixed Costs < 12,000
2. Find out the Financial Leverage from the fo llowing data :
Net Worth < 25,00,000
Debt I Equ ity 3:1
Interest Rate 12%
Operating Profit < 20,00,000

Solution
1. Operating Leverage :

Sales 50,000
- Variable Cost at 60% 30,000
Contribution 20,000
- Fixed Cost 12,000
0 eratin Profit 8 000
Business Risk and Financial Risk 217

Contribu tion
Operating Leverage
Operating Profit
20,000
8,000
2.50

2. Financial Leverage :

Net Worth 25,00,000

Debt/ E quity 3: 1
Debt 75,00,000
EBIT 20,00,000
- Interest at 12% on < 75,00,000 9,00,000
PBT 11 00 000
Earn ings Before Interest & Tax (EBIT)
Financia l Leverage
Profit Before Tax (PBT)
20,00,000
11,00,000
1.82
Illustration : 1O
From the fo llowing information avai lab le for 4 firms, calcu late the Earnings Before Interest and Tax
(EBIT), Earnings per Share(EPS), the Operating Leverage and the Financial Leverage :
Fir ms
p Q R s
Sales (in Units) 20,000 25,000 30,000 40,000
Selling Price per Unit (<) 15 20 25 30
Variable Cost per Unit(<) 10 15 20 25
Fixed Costs (<) 30,000 40,000 50,000 60,000
Interest (<) 15,000 25,000 35,000 40,000
Tax % 40 40 40 40
Number of Equity Shares 5,000 9 ,000 10,000 12,000
Solution
Calculation ofEBIT, EPS,
Operating Leverage and Financial Leverage
Fir ms
p Q R s
Sales (in Units) 20,000 25,000 30,000 40,000
< < < <
Contr ibution (< 5 per Unit) 1,00,000 1,25,000 1,50,000 2,00,000
- Fixed Costs 30,000 40,000 50,000 60,000
EBIT70,000 85,000 1,00,000 1,40,000
- Interest 15,000 25,000 35,000 40,000
Profit before Tax 55,000 60,000 65,000 1 ,00,000
- Tax @ 40% 22,000 24,000 26,000 40,000
Profit After T ax 33 000 36 000 39 000 60 000
Number of Equity Shares 5,000 9,000 10,000 12,000
E PS (<) 6.60 4.00 3.90 5.00
Contribution
Operating Leverage = 1.43 1.47 1.50 1.43
EBIT
EBIT
Financial Leverage = Profit Before Tax 1.27 1.42 1.54 1.40

Illustration : 11
A firm has Sales of< 75,00,000; Variable Cost< 42,00,000 and Fixed Cost of< 6,00,000. It has a Debt
of< 45,00,000 at 9% and Equity of< 55,00,000.
a) What is the firm's ROI?
b) Does it have a favourable Financ ia l Leverage?
c) If the firm belongs to an industry, whose asset turnover is 3, does it have a high or low asset
leverage?
2/8 Financial Management-Tl (S. YB.B.l.) (Sem. - IV)

d) What are the Operating, Financial and Combined Leverages of the firm?
e) If the Sales drop tot 50,00,000; what w ill be the new EBIT?
Solution

Sales 75,00,000
Less : Variable Cost 42,00,000
Contribution 33,00,000
Less : Fixed Costs 6,00,000
EBIT 27,00,000
Less : 9% Interest on t 45,00,000 4,05,000
EBT 22.95.000
EBIT
a) Return on Investment (ROI)
Investment
EBIT
Debit + Equity
27,00,000
1,00, 00,000 X l OO
27%
b) Return on Investment (27%) is higher than the Interest payable on Debt at 9%. Hence, the firm has a
favourable financial leverage.
Net Sales
c) Asset Turnover
Total Assets or Tota l Investment
75,00,000
Asset Turnover
1,00,00,000
0.75
The Industry Average is 3. Hence, the firm has low Asset Leverage.
Contribution
d) Operating Leverage
EBIT
33,00,000
27,00,000
1.22
EB IT
Financial Leverage
EBT
27,00,000
22,95,000
1.18
Contribution
Combined Leverage
EBT
33,00,000
22,95,000
1.44
OR
Operating Leverage x Fi nancial Leverage
= 1.22 X 1.18
= 1.44
e) If the Sales drop to t 50,00,000 from t 75,00,000; the fa ll is by 33.33%. Hence, EBIT will drop by
40.67%, i.e.
(%Fallin Sales x Operating Leverage) or (33 .33 x 1.22)
Hence, the new EB IT w ill be :
t 27,00,000 X (1 - 40.67%) = t 16,01,910

Illustration: 12
The selected financial data for A, B and C companies for the year ended 31st March, 2018 were as
follows :
Business Risk and Financial Risk 219

A B C
Variable Cost as a Percentage of Sales 66a 75 50
3
Interest Expenses (~) 200 300 1,000
Degr ee of Operating Leverage 5 6 2
Degr ee of Financial Leverage 3 4 2
Income Tax Rate % 40 40 40
Prepare an Income Statement for each of the three compan ies.
Solution
A Ltd.:
1. Calculation of EBIT :
EB IT
Financial Leverage
EBT
EB IT
3
EB IT- Interest
E BIT
3
EB IT- 200
3 EB IT - 200 EB IT
2EBIT 600
600
EBIT 300
2
2. Calculation of C ontribution :
Contribution
Operating Leverage
EB IT
Contribution
5
300
Contribution 1,500
3. Calculation of Fixed Cost :
Fixed Cost Contribution EBIT
3,000 - 300
2,700
4. Calculation of Variable C ost:
Contribution 33.33% of Sales
100
Sales 3,000 x _
33 33
9,000
Variable Cost 66.67% of Sales
66.67% of9,000
6,000
B Ltd. :
1. Calculation of EBIT :
EBIT
Financial Leverage
EBT
EBIT
4
EBIT- Interest
EBIT
4
EB IT- 300
4 EB lT 1,200 EBIT
3 EBIT 1,200
EBIT 1,200 = 400
3
2. Calculation of C ontribution :
Contribution
Operating Leverage
EB IT
Contribution
6
400
Contribution 2,400