BULACAN POLYTECHNIC COLLEGE

McArthur Highway, Barangay Bulihan, City of Malolos, Bulacan 3000

Name of Instructor: EUGENE A. RUANO

School Term: 2nd Semester, A.Y. 2019-2020
Subject Code & Title: FMan 223-Financial Management
Date Covered: April 3, 2020-BSAIS2A

MODULE IN FMAN 223-FINANCIAL MANAGEMENT

I. Subject Matter:

Topic Title: OPERATING AND FINANCIAL LEVERAGE (Chapter 8)

Sub-Topics/Lesson/Discussion: Introduction, Leverage in a Business, CVP

Analysis, Sales Mix, Operating Leverage, Limitations of Analysis, Financial
Leverage, and Combining Operating and Financial Leverage

Lesson Proper
Discussion of the topics on operating & financial leverage
(lecture/discussion)
INTRODUCTION
 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 within 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 will you finance the business. If you reply on
debt financing and the business is successful, you will generate substantial
profits as on 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 you can 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 (Cost-Volume-Profit) ANALYSIS
 Is a powerful tool and vital in many business decisions because it helps
managers understand the relationship among cost, volume and profit. Cost-
volume-profit 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. It answers a variety of critical questions such
as:
1. What is the company’s breakeven volume?
2. What is its margin of safety?
3. 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 this ratio
is computed as follows:
CM ratio = Contribution Margin
Sales
 A. Application
In a ½ sheet of yellow paper crosswise, what is meant by a product’s contribution
margin ratio? How is this ratio useful in planning business operations?

II. Evaluation/Quiz (10 Points)

Instruction: Solve the following problems below in a ½ sheet crosswise yellow paper.
1. Mariah Corporation is a distributor of sun umbrella used at resort hotels. Data
concerning the next month’s budget appear below:
Selling price P30 per unit
Variable expenses P20 per unit
Fixed expenses P7,500 per month
Unit sales 1,000 units per month
a. Compute the company’s margin of safety.
b. Compute the company’s margin of safety as a percentage of its
sales.

III. Assignment
1. What are trade or commercial credit, consumer or retail credit, and credit policy
in relation to accounts receivable management; and inventory management and
its objectives? Answers should be in a ½ sheet crosswise yellow paper.

Prepared by:

EUGENE A. RUANO
Instructor