## How to Compute Operating and Financial Leverage

Leverage is that portion of the fixed costs which represents a risk to the firm. Operating leverage, a measure of operating risk, refers to the fixed operating costs found in the firm’s income statement. Financial leverage, a measure of financial risk, refers to financing a portion of the firm’s assets, bearing fixed financing charges in hopes of increasing the return to the common stockholders. The higher the financial leverage, the higher the financial risk, and the higher the cost of capital. Cost of capital rises because it costs more to raise funds for a risky business.

This post provides technical guidelines on how to determine operating and financial leverage. Enjoy!

A discussion of break-even analysis, broadly known as cost/volume/profit analysis, is necessary for understanding the nature and importance of operating leverage. So, before I jump to the financial leverage, let me briefly discuss break-even analysis first. Read on…

### Computing Break-Even Analysis

The break-even point is the level of sales at which no profit or loss results. To determine the breakeven point, the costs must be divided into:

• Variable Costs – which are costs that vary in direct proportion to a change in volume; and
• Fixed Costs – which are costs that are constant regardless of volume.

The break-even point can be found easily by setting sales just equal to the total of the variable costs plus the fixed costs:

Let:

• S = Sales (\$)
• X = Sales volume in units
• P = Selling price per unit
• V = Unit variable cost
• VC = Variable operating costs
• FC = Fixed operating costs

Then:

S = VC + FC
PX = VX + FC
(P – V)X =  FC
X =  FC / (P- V)

or:

Break-Even Sales In Units

= fixed operating costs / (unit selling price – unit variable cost)

Case Example

The Lie Dharma Company manufactures and sells doors to home builders. The doors are sold for \$25 each. Variable costs are \$15 per door, and fixed operating costs totaling \$50,000. The company’s break-even point is:

X = FC/ (P-V) = \$50,000/(\$25-\$15) = 5,000 doors

Therefore, the company must sell 5,000 doors to break even.

### Computing Cash Break-Even Point

If a firm has a minimum of available cash or the opportunity cost of holding excess cash is high, management may want to know the volume of sales that will cover all cash expenses during a period. This is known as the “Cash Break-even Point”.

Not all fixed operating costs involve cash payments. For example, depreciation expenses are non-cash charges. To find the cash break-even point, the non-cash charges must be subtracted from total fixed operating costs. Therefore, the cash break-even point is lower than the usual break-even point. The formula is:

X = (FC – d)/ (P – V)  –> where d is depreciation expenses

Case Example

Assume from the previous example that the total fixed operating costs of \$50,000 include depreciation in the amount of \$2,000. Then the Lie Dharma Company cash break-even point is:

X = (FC–d)/(P-V) = (\$50,000-\$2,000)/(\$25-\$15) = \$48,000/\$10 = 4,800 doors

The company has to sell 4,800 doors to cover only the fixed costs involving cash payments of \$48,000 and to break even.

Now, we have the foundation enable us to jump to the leverage analysis. Let’s start with the operating leverage. Read on…

### How to Compute Operating Leverage

As mentioned on the preface, “Operating Leverage” is a measure of operating risk and arises from fixed operating costs. A simple indication of operating leverage is the effect that a change in sales has on earnings. The formula is:

“Operating Leverage” at a given level of sales (X)

= percentage change in EBIT/percentage change in sales = (P-V)X/(P-V)(X- FC)

Where:

EBIT = earnings before interest and taxes = (P-V)X – FC

Case Example

From the first example, assume that the Lie Dharma Company is currently selling 6,000 doors per year. Its operating leverage is:

= [(P – V)X]/ (P – V) (X –FC)
= [(\$25 – \$15)(6,000)]/ [(\$25- \$15) (6,000)- \$50,000]
= \$60,000 / 10,000 = 6

Which mean if “Sales” increase by 10 percent, the company can expect its “net income” to increase by six times that amount, or 60 percent.

### How To Calculate Financial Leverage

Financial Leverage” is a measure of financial risk and arises from fixed financial costs. One way to measure financial leverage is to determine how ‘Earnings Per Share [EPS]” are affected by a change in EBIT (or operating income). The formula is:

“Financial Leverage” at a given level of sales (X)

= percentage change in EPS / percentage change in EBIT
= [(P – V)X – FC] / [(P – V)X – FC – IC]

Where EPS is earnings per share, and IC is “Fixed Finance Charges”, i.e., “Interest Expense” or “Preferred Stock Dividends”. [Note: Preferred Stock Dividend must be adjusted for taxes i.e., Preferred Stock Dividend/(1-t).]

Case Example

Using the data in the operating leverage, the Lie Dharma Company has total financial charges of \$2,000, half in “Interest Expense” and half in “Preferred Stock Dividend”. The “Corporate Tax Rate” is 40 percent. What is their financial leverage?

First, Calculate the “Fixed Finance Charge [IC]:

IC = \$1,000 + (\$1,000/1- 0.4) = \$1,000 + \$1,667 = \$2,667

Therefore, Lie Dharma’s financial leverage is computed as follows:

= [(P-V)X –FC] / [(P-V)X-FC-IC]
= [(\$25 – \$15) 6,000- \$50,000] / [(\$25-\$15)6,000 – \$50,000 -\$2,667]
= \$10,000 / \$7,333
= 1.36

Which mean that if EBIT increases by 10 percent, Lie Dharma can expect its EPS to increase by 1.36 times, or by 13.6 percent.

### How To Compute Total Leverage

“Total Leverage” is a measure of total risk. The way to measure total leverage is to determine how EPS is affected by a change in sales. The Formula is:

“Total Leverage” at a given level of sales (X)

= percentage change in EPS / percentage change in sales
= operating leverage x financial leverage
=  [(P-V)X / (P –V)X – FC] x [(P – V)X – FC/(P-V)X – FC – IC]
=  [(P – V)X / [(P – V)X – FC – IC]

Case Example

From the operating and financial leverage examples, the total leverage for Lie Dharma Company is:

Operating leverage x  financial leverage = 6 x 1.36 = 8.16

or

= [(P – V)X] / [(P-V)X – FC – IC]
= (\$25 – \$15) (6,000) / [(\$25 – \$15) 6,000 – \$50,000 – \$2,667
= \$60,000 / \$7,333 = 8.16 (rounded)

## Preparing Financial Statement [Case Study]

How good is your technical skill to prepare financial statement? Very good, you said. Alright, try these challenging cases, you are going to be able to measure how good you’re in this area.  This post provides 2 case studies on how to prepare financial statement. Although they are not types of advance accounting cases, I consider these cases are relatively rich in issues, therefore they reveal many important [and maybe rarely] transactions that you never found in other case.

• For the “income statement preparation [Case-1], a condensed trial balance has been provided, you are required to prepare income statement which is moderate, thought, but then you are also required to prepare a schedule reconciling financial statement “net income” to “taxable income” for the year ended.
• As for the “balance sheet preparation[Case-2],  an unaudited balance sheet is provided, assumed that you are engage in auditing the company and you found some incorrect treatment, calculations and records. In this case you are required to prepare corrected and classified balance sheet for the year ended with a proper heading.

Do not not worry, guidelines and answers are also provided :-). I hope these two case studies enrich your skill in preparing financial statement. Enjoy!

### Case-1. Preparing Income Statement and Taxable Income Recon

The following condensed trial balance of Putra Corp., a publicly owned company, has been adjusted except for income tax expense:

Other information and financial data for the year ended June 30, 2010, follows:

• The weighted-average number of common shares outstanding during 2010 was 200,000. The potential dilution from the exercise of stock options held by Putra’s officers and directors was not material.
• There were no dividends-in-arrears on Putra’s preferred stock at July 1, 2009. On May 1, 2010, Putra’s directors declared a 5% preferred stock dividend to be paid in August 2010.
• During 2010, one of Putra’s foreign factories was expropriated by the foreign government, and Putra received a \$900,000 payment from the foreign government in settlement. The carrying value of the plant was \$650,000. Putra has never disposed of a factory.
• Administrative expenses includes a \$5,000 premium payment for a \$1,000,000 life insurance policy on Putra’s president, of which the corporation is the beneficiary.
• Putra depreciates its assets using the straight-line method for “financial reporting purposes” and an accelerated method for “tax purposes“. The differences between book and tax depreciation are as follows:

June 30            Financial statements over (under)
tax depreciation

2010                \$(15,000)
2011                   10,000
2012                     5,000

There were no other temporary differences.

• Putra’s enacted tax rate for the current and future years is 30%.

Required:

a. Using the single-step format, prepare Putra’s income statement for the year ended June 30, 2010.

b. Prepare a schedule reconciling Putra’s financial statement net income to taxable income for the year ended June 30, 2010.

### Solution to Case-1:

Here is how you should understand the above problem:

[1]. This problem consists of two related parts requiring a single-step income statement and a schedule reconciling net income to taxable income; and

[2]. Part a. requires preparation of a single-step income statement. In a single-step income statement, total expenses and losses are subtracted from total revenues and gains to compute income. There are no “steps” resulting in subtotals such as gross profit, income from operations, etc. For any format income statement, however, nonrecurring items such as extraordinary items, discontinued operations, and cumulative effect of change in accounting principle are reported separately.

[2.1]. Revenues and gains listed in the trial balance include machine sales, service revenues, interest revenue, and gain on sale of factory. The gain is not listed in the revenues and gains section because it is an extraordinary item. The gain is extraordinary because it is unusual, infrequent and results from an expropriation. APB 30 specifies expropriations as an example of an extraordinary item.

[2.2]. Expenses and losses listed in the trial balance include cost of sales, cost of services, administrative expenses, research and development expenses, interest expense, and loss from asset disposal.

[2.3]. One expense not listed in the trial balance is income tax expense, which has not yet been recorded. To compute the current portion of income tax expense on ordinary income, first the expenses and losses listed in 2.1 are subtracted from the revenues (excluding the extraordinary item) listed in 2.2. The difference of \$30,000 is income before income tax and extraordinary item. The amount must be adjusted for permanent and temporary differences to compute taxable income (excluding extraordinary item). The \$5,000 life insurance premium payment must be added back because it was deducted to compute accounting income, but is not deductible for tax purposes, (permanent difference). The \$15,000 excess tax depreciation (temporary difference) must be subtracted. Therefore, taxable income, excluding the extraordinary item, is \$20,000 (=\$30,000 + \$5,000 – \$15,000). Since the tax rate is 30%, the current portion of income tax expense is \$6,000 (=\$20,000 x 30%).

[2.4]. The deferred portion of income tax expense is computed by multiplying the future taxable amounts (\$10,000 + \$5,000 = \$15,000) by the future enacted tax rate of 30% (=30% x \$15,000 = \$4,500).

[2.5]. After computing tax expense, other revenues (\$1,010,000) less total expenses (\$990,500) equals income before extraordinary item (\$19,500). Note that the two components of income taxes could have been disclosed after “income before income taxes and extraordinary item“, which would be \$30,000 (see 2.3).

[2.6]. As discussed in 2.1, the gain from the expropriation of the factory (\$250,000) is an extraordinary item. Per APB 30, extraordinary items must be reported separately, and net of their tax effect. Since the \$250,000 gain is taxable, the gain must be reported at \$175,000 (=\$250,000 less tax effect of 30% x \$250,000). Therefore, “net income” is \$194,500 (=\$19,500 + \$175,000).

[2.7]. Earnings per share (EPS) must be reported on income before extraordinary items and on net income, in accordance with SFAS 128. EPS on the extraordinary gain may be shown either on the face of the IS or in the notes to the FS. The 2002 cumulative preferred dividends (\$2,000,000 x 5% = \$100,000) must be subtracted from the income amounts to determine the amount available to common stockholders. This result is then divided by the weighted-average number of common shares outstanding. Earnings per share on income before extraordinary gain is:

• \$19,500 income – \$100,000 pref. dividends / 200,000 weighted-average shares = (\$0.40)
• Next, the extraordinary gain per share is \$0.87 = [\$175,000/200,000].
• Finally, net income per share is \$0.47 (=\$0.40 + \$0.87).

Next is Part b. It requires the preparation of a schedule reconciling net income to taxable income.

[3.1]. Net income from part a. is \$194,500. This must be adjusted for any items that affect net income but not taxable income, or vice versa.

[3.2]. Income taxes (current, deferred, and on the extraordinary item) decrease net income, but do not affect taxable income. Therefore, these amounts (\$6,000; \$4,500; \$75,000) must be added back to net income.

[3.3]. The officer’s life insurance expense (\$5,000) also reduces net income, but is not deductible for tax purposes. Therefore, it, too, must be added back to net income.

[3.4]. The excess tax depreciation (\$15,000) is deductible on the tax return but is not an expense on the income statement. This item must be deducted to reconcile to taxable income.

[3.5]. The resulting taxable income (\$270,000) can be computed directly to check its correctness as follows:

And, here is Putra’s single-step format income statement for the year ended June 30, 2010, with reconciliation of Putra’s financial statement net income to taxable income for the year ended June 30, 2010, below:

### Case-2. Preparing Balance Sheet

Presented below is the unaudited balance sheet as of December 31, 2010, prepared by the bookkeeper of Lie Dharma Manufacturing Corp.

Your firm has been engaged to perform an audit, during which the following data are found:

• Checks totaling \$14,000 in payment of accounts payable were mailed on December 30, 2010, but were not recorded until 2011. Late in December 2010, the bank returned a customer’s \$2,000 check, marked “NSF [No Sufficient Funds]”, but no entry was made. Cash includes \$100,000 restricted for building purposes.
• Included in accounts receivable is a \$30,000 note due on December 31, 2006, from Lie Dharma’s president.
• During 2010, Lie Dharma purchased 500 shares of common stock of a major corporation that supplies Lie Dharma with raw materials. Total cost of this stock was \$51,300, and market value on December 31, 2010, was \$47,000. The decline in market value is considered temporary. Lie Dharma plans to hold these shares indefinitely.
• Treasury stock was recorded at cost when Lie Dharma purchased 200 of its own shares for \$32 per share in May 2010. This amount is included in investments.
• On December 30, 2010, Lie Dharma borrowed \$500,000 from a bank in exchange for a 10% note payable, maturing December 30, 2007. Equal principal payments are due December 30 of each year, beginning in 2011. This note is collateralized by a \$250,000 tract of land acquired as a potential future building site, which is included in land.
• The mortgage payable requires \$50,000 principal payments, plus interest, at the end of each month. Payments were made on January 31 and February 28, 2011. The balance of this mortgage was due June 30, 2012. On March 1, 2011, prior to issuance of the audited financial statements, Lie Dharma consummated a noncancelable agreement with the lender to refinance this mortgage. The new terms require \$100,000 annual principal payments, plus interest, on February 28 of each year, beginning in 2012. The final payment is due February 28, 2028.
• The lawsuit liability will be paid in 2011.

The following is an analysis of the deferred tax liability at December 31, 2010:

Deferred taxes related to depreciation        = \$48,000
Deferred taxes related to a lawsuit liability = (20,000)
Net deferred tax liability                             = \$28,000

• The current income tax expense reported in Lie Dharma’ 2010 income statement was \$61,200.
• The company was authorized to issue 100,000 shares of \$50 par value common stock.

Required:

Prepare a corrected classified balance sheet as of December 31, 2010. This financial statement should include a proper heading, format, and necessary descriptions.

### Solution to Case-2:

[1]. In this problem, a corrected, classified 12/31/10 balance sheet with proper format and necessary descriptions must be prepared. The solutions approach is to first write the correct statement heading on paper. Second, skim the incorrect balance sheet provided, then go through the additional data to determine the necessary adjustments and disclosures. As you do this, label each item CA, CL, investment, etc.

[2]. The unrecorded payment on accounts payable should be recorded at 12/30/09, resulting in a \$14,000 decrease in cash and accounts payable.

[2.1]. No entry was made for the customer’s NSF check (\$2,000), which should be recorded as a decrease in cash and an increase in accounts receivable (since the customer still owes Lie Dharma \$2,000).

[2.2]. Cash restricted for building purposes (\$100,000) must be reported separately from unrestricted cash. Restricted cash is classified either as current or long-term depending on the expected date of disbursement. In this case, since the cash is restricted for future building purposes, it is classified as long-term.

[2.3]. The \$30,000 note receivable from Lie Dharma’ president should be reported separately from accounts receivable, reducing AR by the same amount. The note should be classified as long-term since it is not due until 12/31/13.

[2.4]. Current assets should include cash (\$225,000 – \$14,000 – \$2,000 – \$100,000 = \$109,000), accounts receivable, net (\$345,700 + \$2,000 – \$30,000 = \$317,700) and inventories (\$560,000). The restricted cash (\$100,000) and notes receivable (\$30,000) are reported as other assets.

[3]. The next two items of additional data concern the investments account, which is reported in the bookkeeper’s balance sheet at \$57,700 [= \$51,300 cost of investment plus \$6,400 cost of treasury stock (200 x \$32)].

[3.1]. The cost of treasury stock (\$6,400) should be removed from the investments account and reported as a separate reduction of stockholders’ equity. This brings the investment account down to a balance of \$51,300 (=\$57,700 – \$6,400), which is the cost of the investment.

[3.2]. The remaining investment consists of shares of stock of a major corporation, which indicates that these are “marketable equity securities [MES]“, which should be reported at market. Since cost is \$51,300 and market value is \$47,000, an unrealized loss should be recorded at \$4,300 (\$51,300 – \$47,000). The unrealized loss is reported as a separate component of stockholder’s equity entitled “accumulated other comprehensive income” because these MES should be classified as “available-for-sale”. Additionally, the investment account should be reduced by \$4,300. Note that the shares acquired were those of a supplier. Since the percentage of outstanding shares represented by the 500 shares is unknown, “available for sale” appears to be the proper treatment.

[3.3]. The land held as a potential future building site (\$200,000) is shown under “other assets” in the AICPA answer. It would also be acceptable to classify the land as an investment.

[4]. None of the additional data gives any information on the amounts reported as land, building, machinery, and equipment, or accumulated depreciation, except for the information about the land held as a potential future plant site (see 3.3 above).

[4.1]. Property, plant, and equipment consists of land (\$450,000 – \$250,000 = \$200,000), building (\$1,750,000), and machinery and equipment (\$1,964,000). Accumulated depreciation (\$420,000) is subtracted from the building, machinery, and equipment.

[4.2]. Goodwill (\$37,000) is reported as an intangible asset.

[5]. The next few items of additional information involve liabilities. The main concern is determining classification as current or long-term.

[5.1]. The notes payable (\$500,000) are classified as \$100,000 current (for the installment due 12/30/09) and \$400,000 long-term (for the remaining four installments).

[5.2]. The mortgage payable would generally be reported as \$600,000 current (12 x \$50,000) and the remaining \$300,000 long-term (\$900,000 – \$600,000). However, after two \$50,000 installments were paid, the remaining \$800,000 was refinanced on a long-term basis. Per SFAS 6, a short-term obligation can be reclassified as long-term if the enterprise intends to refinance the obligation on a long-term basis and the intent is supported by the ability to refinance. Lie Dharma demonstrated its intent and ability to refinance \$800,000 of the mortgage when it actually refinanced that amount on 3/1/10, before the 12/31/09 financial statements were issued. Therefore, in the 12/31/09 balance sheet, \$100,000 of the mortgage should be classified as current and \$800,000 as long-term.

[5.3]. The lawsuit liability (\$80,000) is classified as current since it will be paid in 2010.

[5.4]. Income taxes payable (\$61,200) is the amount recorded as the current portion of income tax expense in the 2010 income statement. Lie Dharma also has recorded \$40,000 of prepaid income taxes, which apparently represents estimated tax payments made during 2010. Therefore, the net income taxes payable to be reported as a current liability at 12/31/03 is \$21,200 (=\$61,200 – \$40,000).

[5.5]. The classification of deferred tax liabilities and assets is a two-step process. First, all deferred tax liabilities and assets are classified as current or long-term. Once classified, all current items are netted to determine either a current asset or liability, and all long-term items are similarly netted. In this case, a noncurrent DT [=Deferred Tax] liability of \$48,000 exists due to the depreciation difference and a current DT asset of \$20,000 exists due to the lawsuit liability difference. These should not be netted. A \$20,000 current deferred tax asset is reported. In addition, there is a long-term deferred tax liability of \$48,000 caused by the depreciation difference.

[5.6]. Accounts payable is reported as a current liability at \$119,800 (\$133,800 less the \$14,000 adjustment discussed in item 2 above).

[6]. In the stockholders’ equity section common stock is reported at the par value of the shares issued (\$40,000 x \$50 = \$2,000,000). Additional disclosures for the common stock are the number of shares authorized, issued, and outstanding, and the par value per share.

[6.1]. Paid-in capital in excess of par is the excess of the issue price of the stock (the \$2,231,000 balance reported in the bookkeeper’s balance sheet) over the par value of \$2,000,000 (=\$2,231,000 – \$2,000,000 = \$231,000).

[6.2]. The other stockholders’ equity items are retained earnings (given at \$1,075,400) and the two items discussed earlier: treasury stock (see 3.1 above) and the unrealized loss (see 3.2 above).

[6.3]. Once you have identified where each element should go in the BS, prepare the statement.

And here is the corrected, classified balance sheet as of December 31, 2010 with a proper heading, format, and necessary descriptions.

Explanations of Amounts

[1] Cash, per unaudited balance sheet       \$ 225,000
Less: Unrecorded checks in payment
of accounts payable                                      (14,000)
NSF check not recorded                                  (2,000)
Cash restricted for rebuilding purposes
(reported in other assets)                            (100,000)
Corrected balance                                       \$109,000

[2] Accounts receivable (net),
per unaudited balance sheet                        \$345,700
Add charge-back for NSF check (see [1])           2,000
Less officer’s note receivable (reported in
other assets)                                                  (30,000)
Corrected balance                                        \$317,700

[3] Investments, per unaudited
balance sheet                                                \$ 57,700
Less: Long-term investment
(reported separately)                                      (47,000)
Write-down of investment to market               (4,300)
Treasury stock (reported in
stockholders’ equity)                                       (6,400)
Corrected balance                                                  \$ 0

[4] Land, per unaudited balance sheet       \$ 450,000
Less land acquired for future building
site (reported in other assets)                      (200,000)
Correct balance                                            (250,000)

[5] Accounts payable,
per unaudited balance sheet                      \$ 133,800
Less unrecorded payments (see [1])              (14,000)
Corrected balance                                      \$ 119,800

[6] Mortgage payable,
per unaudited balance sheet                      \$ 900,000
Less current portion (\$50,000 x 2)              (100,000)
Refinanced as long-term
mortgage payable                                       \$800,000

[7] Note payable, per unaudited
balance sheet                                          \$ 500,000
Less current portion                                 (100,000)
Long-term note payable                         \$ 400,000

[8] Income taxes payable,
per unaudited balance sheet                     \$ 61,200
Less prepaid income taxes                        (40,000)
Corrected balance                                      \$21,200

[9] Common stock, per unaudited
balance sheet                                        \$2,231,000
Less additional paid-in capital
in excess of par value                               (231,000)
Corrected balance                                  \$2,000,000