What will be the financial leverage, if sales (1,00,000 units) is Rs. 2,00,000; variable cost per unit is Rs. 0.70; fixed cost is Rs. 65,000 and interest charge is Rs. 15,000?

Question

Accepted Answer

The correct option is 4:
The concept of Financial Leverage (FL) is a fundamental tool in financial management that measures the sensitivity of a company's Earnings Per Share (or Earnings Before Taxes) to changes in its Earnings Before Interest and Taxes (EBIT). It essentially captures the risk associated with a company's debt financing. The formula for Financial Leverage is FL = Earnings Before Interest and Taxes (EBIT) / Earnings Before Taxes (EBT). To calculate this: first, find the Total Variable Cost (Rs. 1,00,000 units \* Rs. 0.70/unit = Rs. 70,000). Next, calculate EBIT: Sales (Rs. 2,00,000) - Variable Cost (Rs. 70,000) - Fixed Cost (Rs. 65,000) = Rs. 65,000. Then, calculate EBT: EBIT (Rs. 65,000) - Interest Charge (Rs. 15,000) = Rs. 50,000. Finally, FL = EBIT / EBT = Rs. 65,000 / Rs. 50,000, which equals **1.3 times**. This indicates that a 1% change in EBIT would result in a 1.3% change in EBT.

The incorrect option is 1:
The value 2.0 times (Rs. 65,000 / Rs. 50,000 $\ne$ 2.0) is not the financial leverage for this problem. This value actually represents the Degree of Operating Leverage (DOL). DOL is calculated as Contribution / EBIT. The Contribution is Sales (Rs. 2,00,000) - Variable Cost (Rs. 70,000) = Rs. 1,30,000. Therefore, DOL = Rs. 1,30,000 / Rs. 65,000 = 2.0 times. While this is a related leverage concept, it measures business risk, not financial risk.

The incorrect option is 2:
The option 1.5 times is not correct. This value would require the EBIT to be Rs. 75,000 if the EBT remained Rs. 50,000 (Rs. 75,000/Rs. 50,000 = 1.5). This would mean the Fixed Cost or Variable Cost calculation was incorrect, as the actual EBIT is Rs. 65,000.

The incorrect option is 3:
The option 1.2 times is not correct. For the financial leverage to be 1.2, the ratio of EBIT to EBT would need to be 1.2 (EBIT/EBT = 1.2). With the calculated EBIT of Rs. 65,000 and EBT of Rs. 50,000, this option represents a miscalculation in the final step of the formula.