MB0045 Financial Management Assignment Set- 1

Q.1 Write the short notes on 1. Financial management 2. Financial planning 3. Capital structure 4. Cost of capital 5. Trading on equity.
1. Financial management: Financial Management is art and science of managing money. It embraces all managerial activities that are required to procure funds at the least cost and their effective deployment Traditionally, Financial Management was considered a branch of knowledge with focus on procurement of funds. The core of modern approach evolved around the procurement of the least cost funds and its effective utilization for maximization of shareholders wealth. The most admired Indian companies are Reliance and Infosys. They employ the best technology, produce good quality goods or render services at the least cost and continuously contribute to the shareholders wealth. The three core elements of financial management are:Financial control, Financial Planning and Financial decisions. Financial planning is the assurance of capital investment to procure real assets to run the business smoothly. Financial control involves management of day to day business of the company by receiving or collecting money due from clients or debtors and payments to various suppliers or creditors. Financial decisions: decisions as regards to the funds that are needed by the company from various sources namely debt and equity. How much is needed from these sources would be decided for formulating the financial plan.

2. Financial planning:
In business, a financial plan can refer to the three primary financial statements (balance sheet, income statement, and cash flow statement) created within a business plan. Financial forecast or financial plan can also refer to an annual projection of income and expenses for a company, division or department. A financial plan can also be an estimation of cash needs and a decision on how to raise the cash, such as through borrowing or issuing additional shares in a company Financial planning is the assurance of capital investment to procure real assets to run the business smoothly. A financial plan can also be an investment plan, which allocates

savings to various assets or projects expected to produce future income, such as a new business or product line, shares in an existing business, or real estate Financial planning is the task of determining how a business will afford to achieve its strategic goals and objectives. Financial plan can be a budget, a plan for spending and saving future income.. While a financial plan refers to estimating future income, expenses and assets, a financing plan or finance plan usually refers to the means by which cash will be acquired to cover future expenses, for instance through earning, borrowing or using saved cash.

3. Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. The mix of long term sources of funds like debentures, loans, preference shares and retained earnings in different ratios. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. In short, it is the financing plan of the company. With the object of maximizing the value of the equity share, by using correct proportion of debt and equity which will aim achieving the firm objective. The value of the company is dependant on its expected future earnings and the required rate of return. The proper mix of funs is referred to as optimal capital structure. The caital structure decisions include debt-equity mix and dividend decisions. Capital structure can be of various kinds as described below: Horizontal capital structure: the firm has zero debt component in the structure mix. Expansion of the firm takes through equity or retained earnings only. Vertical capital structure: the base of the structure is formed by a small amount of equity share capital. This base serves as the foundation on which the super structure of preference share capital and debt is built. Pyramid shaped capital structure: this has a large proportion consisting of equity capita; and retained earnings. Inverted pyramid shaped capital structure: this has a small component of equity capital, reasonable level of retained earnings but an ever-increasing component of debt.

SIGNIFICANCE OF CAPITAL STRUCTURE: Reflects the firms strategy Indicator of the risk profile of the firm Acts as a tax management tool Helps to brighten the image of the firm.

FACTORS INFLUENCING CAPITAL STRUCTURE: Corporate strategy Nature of the industry Current and past capital structure

4. Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. A company not being able to meet these demands may face the risk of investors taking back their investments thus leading to bankruptcy. Loans and debentures come with a pre-determined interest rate. Preference shares also have a fixed rate of dividend while equity holders expect a minimum return of dividend, based on their risk perception and the companys past performance in terms of pay-out dividends. Given below are costs of different sources of finance: 1. Cost of debentures: the cost of debenture is the discount rate which equates the net proceeds from issue of debentures to the expected cash outflows. 2. Cost of term loans: term loans are taken from banks or financial institutions at a pre-determined interest rate for a specified number of years. The cost of term loans is equal to the interest rate multiplied by 1-tax rate. 3. Cost of preference capital: the cost of preference share Kp is the discount rate which equates the proceeds from preference capital issue to the dividend and principal repayments.

4. Cost of equity capital: Equity shareholders do not have a fixed rate of return on
their investment. There is no legal requirement (unlike in the case of loans or debentures where the rates are governed by the deed) to pay regular divisons to them.

5. Trading on equity
In finance, equity trading is the buying and selling of company stock shares. Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporations common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity. If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.

Shares in large publicly-traded companies are bought and sold through one of the major stock exchanges, such as the New York Stock Exchange, London Stock Exchange or Tokyo Stock Exchange, which serve as managed auctions for stock trades. Stock shares in smaller public companies are bought and sold in over-the-counter (OTC) markets. Equity trading can be performed by the owner of the shares, or by an agent authorized to buy and sell on behalf of the share's owner. Proprietary trading is buying and selling for the trader's own profit or loss. In this case, the principal is the owner of the shares. Agency trading is buying and selling by an agent, usually a stock broker, on behalf of a client. Agents are paid a commission for performing the trade. Major stock exchanges have market makers who help limit price variation (volatility) by buying and selling a particular company's shares on their own behalf and also on behalf of other clients.

Q.2 a. Write the features of interim divined and also write the factor Influencing divined policy?
Usually, board of directors of company declares dividend in annual general meeting after finding the real net profit position. If boards of directors give dividend for current year before closing of that year, then it is called interim dividend. This dividend is declared between two annual general meetings. Before declaring interim dividend, board of directors should estimate the net profit which will be in future. They should also estimate the amount of reserves which will deduct from net profit in profit and loss appropriation account. If they think that it is sufficient for operating of business after declaring such dividend. They can issue but after completing the year, if profits are less than estimates, then they have to pay the amount of declared dividend. For this, they will have to take loan. Therefore, it is the duty of directors to deliberate with financial consultant before taking this decision. Accounting treatment of interim dividend in final accounts of company :-

# First Case : Interim dividend is shown both in profit and loss appropriation account and balance sheet , if it is outside the trial balance in given question. ( a) It will go to debit side of profit and loss appropriation account (b) It will also go to current liabilities head in liabilities side. # Second Case: Interim dividend is shown only in profit and loss appropriation account, if it is shown in trial balance.

( a) It will go only to debit side of profit and loss appropriation account. If in final declaration is given outside of trial balance and this will be proposed dividend and interim dividend in trial balance will be deducted for writing proposed dividend in profit and loss appropriation account and balance sheet of company, because if we will not deducted interim dividend, then it will be double deducted from net profit that is wrong and error shows when we will match balance sheets assets with liabilities.

Factors affecting dividend policy. The dividend decision is difficult decision because of conflicting objectives and also because of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders. The factors affecting dividend policy are grouped into two broad categories. 1. Ownership considerations 2. Firm-oriented considerations Ownership considerations: Where ownership is concentrated in few people, there are no problems in identifying ownership interests. However, if ownership is decentralized on a wide spectrum, the identification of their interests becomes difficult. Various groups of shareholders may have different desires and objectives. Investors gravitate to those companies which combine the mix of growth and desired dividends. Firm-oriented considerations: Ownership interests alone may not determine the dividend policy. A firms needs are also an important consideration, which include the following:

Contractual and legal restrictions Liquidity, credit-standing and working capital Needs of funds for immediate or future expansion Availability of external capital. Risk of losing control of organization Relative cost of external funds Business cycles Post dividend policies and stockholder relationships.

1. Stability of Earnings. The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods.

2. Age of corporation. Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. 3. Liquidity of Funds. Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the investment and financial decisions of the firm which in turn determines the rate of expansion and the manner of financing. If cash position is weak, stock dividend will be distributed and if cash position is good, company can distribute the cash dividend. 4. Extent of share Distribution. Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group, would face a great difficulty in securing such assent because they will emphasize to distribute higher dividend. 5. Needs for Additional Capital. Companies retain a part of their profits for strengthening their financial position. The income may be conserved for meeting the increased requirements of working capital or of future expansion. Small companies usually find difficulties in raising finance for their needs of increased working capital for expansion programmes. They having no other alternative, use their ploughed back profits. Thus, such Companies distribute dividend at low rates and retain a big part of profits. 6. Trade Cycles. Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. 7. Government Policies. The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises. 8. Taxation Policy. High taxation reduces the earnings of he companies and consequently the rate of dividend is lowered down. Sometimes government levies dividend-tax of distribution of dividend beyond a certain limit. It also affects the capital formation. N India, dividends beyond 10 % of paid-up capital are subject to dividend tax at7.5%. 9. Legal Requirements. In deciding on the dividend, the directors take the legal requirements too into consideration. In order to protect the interests of creditors an

outsider, the companies Act 1956 prescribes certain guidelines in respect of the distribution and payment of dividend. Moreover, a company is required to provide for depreciation on its fixed and tangible assets before declaring dividend on shares. It proposes that Dividend should not be distributed out of capita, in any case. Likewise, contractual obligation should also be fulfilled, for example, payment of dividend on preference shares in priority over ordinary dividend. 10. Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rat. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organization. 11. Ability to Borrow. Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to built up good reserves by reducing the dividend pay out ratio for meeting any obligation requiring heavy funds. 12. Policy of Control. Policy of control is another determining factor is so far as dividends are concerned. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. So they prefer to meet the needs through retained earning. If the directors do not bother about the control of affairs they will follow a liberal dividend policy. Thus control is an influencing factor in framing the dividend policy. 13. Repayments of Loan. A company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangements are made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. Management is bound to hour such restrictions and to limit the rate of dividend payout. 14. Time for Payment of Dividend. When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. 15. Regularity and stability in Dividend Payment. Dividends should be paid regularly because each investor is interested in the regular payment of dividend. The management should, inspite of regular payment of dividend, consider that the rate of dividend should be all the most constant. For this purpose sometimes companies maintain dividend equalization Fund.

Q2b. What is reorder level?

This is that level of materials at which a new order for supply of materials is to be placed. In other words, at this level a purchase requisition is made out. This level is fixed somewhere between maximum and minimum levels. Order points are based on usage during time necessary to requisition order, and receive materials, plus an allowance for protection against stock out. The order point is reached when inventory on hand and quantities due in are equal to the lead time usage quantity plus the safety stock quantity. Formula of Re-order Level or Ordering Point: The following two formulas are used for the calculation of reorder level or point. [Ordering point or re-order level = Maximum daily or weekly or monthly usage Lead time] The above formula is used when usage and lead time are known with certainty; therefore, no safety stock is provided. When safety stock is provided then the following formula will be applicable: [ Ordering point or re-order level = Maximum daily or weekly or monthly usage Lead time + Safety stock ]

Example: Minimum daily requirement Time required to receive emergency supplies Average daily requirement Minimum daily requirement Time required for refresh supplies Calculate ordering point or re-order level Calculation: Ordering point = Ordering point or re-order level = Maximum daily or weekly or monthly usage Lead time = 800 30 = 24,000 units 800 units 4 days 700 units 600 units One month (30 days)

Q.3 Sales Rs.400, 000 less returns Rs 10, 000, Cost of Goods Sold Rs 300,000, Administration and selling expenses Rs.20, 000, Interest on loans Rs.5000,Income tax Rs.10000, preference dividend Rs. 15,000, Equity Share Capital Rs.100, 000 @Rs. 10 per share. Find EPS. Sales Less returns Less: Cost of goods sold Contributions Less: Administration & selling expenses Earning before interest (EBI) Less: Interest on loans Earnings before tax(EBT) Less: Income tax Earnings after tax(EAT) Less: preference shares Earnings available to equity holders 400000 10000 390000 300000 90000 20000 20000 70000 5000 65000 10000 55000 15000 40000

Earnings per share= Earning available No. of shares outstanding =40000 x 10 =Rs.4 100000 Q.4 What are the techniques of evaluation of investment?
- Three steps are involved in the evaluation of an investment: Estimation of cash flows Estimation of the required rate of return (the cast of capital) Application of a decision rule for decision rule for making the choice

Investment decision rule The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that is should maximize the shareholders wealth. The following other characteristics should also be possessed by a sound investment evaluation criterion: It should consider all cash flows to determine the true profitability of then project. It should provide for an objective and unambiguous way of separate good projects from bad projects. It should help ranking of projects according to their true profitability. It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth. It should be a criterion which is applicable to any conceivable investment project independent of others. These conditions will be clarified as we discuss the features of various investment criteria in the following posts. The methods of appraising an investment proposal can be grouped into 1. Traditional methods 2. Modern methods Traditional methods are: Payback method Accounting rate of return

Modern techniques are: Net present value Internal rate of return Modified internal rate of return Profitability index

Traditional method:
Payback method is defined as the length of time required to recover the initial cash outlay. Its advantages are that its simple in concept and application, recovery of initial outlay, its the best method for evaluation of projects with high uncertainty. It favors a project which is less then or equal to the standard payback set by the management. In this process early cash flows get due recognition then later cash flows. Therefore payback period could be used as a tool to deal with the ranking of projects on the basis of risk criterion. For firms with short age funds this is preferred because it measures liquidity of the project.

If projects are mutually exclusive, select the project which has the least payback period. In respect of other projects, select the project which have pay-back period less than or equal to the standard payback stipulated by the management. Accounting rate of return (ARR) measures the profitability of investment using the information taken from financial statements. It is based on accounting information, simple to understand. It considers the profits of entire economic life of the project. Since it is based on accounting information, the business executives are familiar with the accounting information understand it. If any project which has an excess ARR, the minimum rate fixed by the management is accepted. If actual ARR is less than the cut-off rate then that project. When projects are to be ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR are preferred to the ones with lower ARR.

Discounted pay back period

The length in years required to recover the initial outlay on the value basis is called the discounted pay back period. Discounted pay back period for a project will always be higher then simple pay back period. Discounted cash flow method Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In evaluation of the projects the needs to give weight age to the timing of return is effectively considered in all DCF methods.

Modern methods
Net present value Net present value (NPV) method recognizes the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore there is a need to find out the present values of all cash flows. NPV is the most widely used technique among the DCF method. If Net present value is positive the project should be accepted. If NPV is negative the project should be rejected. NPV method can be used to select between mutually exclusive projects by examining whether incremental investment generate a positive net present value. Internal rate of return (IRR) Internal rate of return is the rate which makes the NPV of any project zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows.

IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns. If the projects internal rate of return is greater than the firms cost of capital, accept the proposal, otherwise reject the proposal. Modified internal rate of return Modified internal rate of return (MIRR) is a distinct improvement over the IRR- internal rate of return. Managers find IRR intuitively more appealing than the rupees of NP because IRR is expressed on a percentage rate of return. Modified rate of return is a better indicator of relative profitability of the projects.

Profitability Index Profitabilty index is also known as benefit cost index. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.
P1=Present value of cash inflows/ Initial cash outlay If profitability index is 1then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows.

Q.5 what are the problems associated with inadequate working capital?
When working capital is inadequate, a firm faces the following problems. Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount. Disadvantages of Redundant or Excessive Working Capital 1. Excessive Working Capital means ideal funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. 2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. 3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts. 4. It may result into overall inefficiency in the organization. 5. When there is excessive working capital, relations with banks and other financial institutions may not be maintained. 6. Due to low rate of return on investments, the value of shares may also fall.

7. The redundant working capital gives rise to speculative transactions. Disadvantages or Dangers of Inadequate Working Capital 1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities. 2. It cannot buy its requirements in bulk and cannot avail of discounts, etc. 3. It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital. 4. The firm cannot pay day-to-day expenses of its operations and its creates inefficiencies, increases costs and reduces the profits of the business. 5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds. 6. The rate of return on investments also falls with the shortage of working capital. Disadvantages or Dangers of Inadequate or Short Working Capital Cant pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI falls sharply

A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has idle funds which earn no profits for the firm. Inadequate working capital means the firm does not have sufficient funds for running its operations. It will be interesting to understand the relationship between working capital, risk and return. The basic objective of working capital management is to manage firms current assets and current liabilities in such a way that the satisfactory level of working capital is maintained, i.e.; neither inadequate nor excessive. Working capital some times is referred to as circulating capital. Operating cycle can be said to be t the heart of the need for working capital. The flow begins with conversion of cash into raw materials which are, in turn transformed into work-in-progress and then to finished goods. With the sale finished goods turn into accounts receivable, presuming goods are sold as credit. Collection of receivables brings back the cycle to cash. The company has been effective in carrying working capital cycle with low working capital limits. It may also be observed that the PBT in absolute terms has been increasing as a year to year basis as could be seen from the above table although profit percentage turnover may be lower but in absolute terms it is increasing. In order to further increase profit margins, SSL can increase their margins by extending credit to good customers and also by paying the creditors in advance to get better rates. Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running of a business. No business can run successfully with out an adequate amount of working capital.

Working capital refers to that part of firms capital which is required for financing short term or current assets such as cash, marketable securities, debtors, and inventories. In other words working capital is the amount of funds necessary to cover the cost of operating the enterprise. Working capital means the funds (i.e.; capital) available and used for day to day operations (i.e.; working) of an enterprise. It consists broadly of that portion of assets of a business which are used in or related to its current operations. It refers to funds which are used during an accounting period to generate a current income of a type which is consistent with major purpose of a firm existence. Every business needs some amount of working capital. It is needed for following purposes For the purchase of raw materials, components and spares. To pay wages and salaries. To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc. To provide credit facilities to customers etc.

Q.6 What is leverage? Compare and Contrast between operating Leverage and financial leverage
Leverage is the action of a lever or the mechanical advantage gained by it; it also means effectiveness or power. The common interpretation of leverage is derived from the use or manipulation of a tool or device termed as lever, which provides a substantive clue to the meaning and nature of financial leverage. When an organization is planning to raise its capital requirements (funds), these may be raised either by issuing debentures and securing long term loan 0r by issuing sharecapital. Normally, a company is raising fund from both sources. When funds are raised from debts, the Co. investors will pay interest, which is a definite liability of the company. Whether the company is earning profits or not, it has to pay interest on debts. But one benefit of raising funds from debt is that interest paid on debts is allowed as deduction for income tax. When funds are raised by issue of shares (equity) , the investor are paid dividend on their investment. Dividends are paid only when the Company is having sufficient amount of profit. In case of loss, dividends are not paid. But dividend is not allowed as deduction while computing tax on the income of the Company. In this way both way of raising funds are having some advantages and disadvantages. A Company has to decide that what will be its mix of Debt and Equity, considering the liability, cost of funds and expected rate of return on investment of fund. A Company should take a proper decision about such mix, otherwise it will face many financial problems. For the purpose of determination of mix of debt and equity, leverages are calculated and analyzed In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:

A public corporation may leverage its equity by borrowing money. The more it borrows, the less equity capital it needs, so any profits or losses are shared among a smaller base and are proportionately larger as a result. A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income. Hedge funds often leverage their assets by using derivatives. A fund might get any gains or losses on $20 million worth of crude oil by posting $1 million of cash as margin

Accounting leverage has the same definition as in investments. There are several ways to define operating leverage, the most common is: Comparison between operating and financial leverage

Operating leverage =Revenue-variable cost/ Revenue-variable cost-Fixed cost= Revenue-variable cost/Operating income Financial leverage is usually defined as:= Operating income/ Net income Operating leverage is an attempt to estimate the percentage change in operating income (earnings before interest and taxes or EBIT) for a one percent change in revenue. Financial leverage tries to estimate the percentage change in net income for a one percent change in operating income. The product of the two is called Total leverage, and estimates the percentage change in net income for a one percent change in revenue. There are several variants of each of these definitions, and the financial statements are usually adjusted before the values are computed. Moreover, there are industry-specific conventions that differ somewhat from the treatment above. Financial leverage is in contrast to operating leverage as it relates to the financial activities of a firm and measures the effect of earnings before interest and tax on earning per share of the company. A companies source of funds fall under two categories Those which carry a fixed charge like debentures, bonds and preference shares Those which do not carry a fixed charge like equity shares. Debentures and bonds carry a fixed rate of interest and have to be paid off irrespective of the firms revenues. Dividend on preference shares have to be paid off before equity shares. Whereas equity share holders are paid the residual income of the firm after all the other obligations are met. Financial leverage refers to the mix of debt and equity in the capital structure of the firm. This results from the fixed financial charges which are present in the companys income

stream. These expenses have nothing to do with the firms earnings or performance and should be paid off regardless of the amount of earnings before income and tax. It is the Firms ability to use fixed financial charges to increase the effects of changes in EBIT on the EPS. It is the use of funds obtained at fixed costs which increase the returns on shareholders. A company which earns more by use of assets funded by fixed sources is said to be having a favorable or positive leverage. Unfavorable leverage occurs when the firm is not earning sufficiently to cover the cost of funds. Financial leverage is also referred to as Trading in Equity Operating leverage arises due to the presence of fixed operating expenses in the firms income flows. A companys operating costs can be categorized into three main sections Fixed costs Variable cost Semi variable cost Fixed costs do not change with an increase in production or sales activities for a particular period of time. Examples are salaries to employees, rents, insurance of the firm and the accountancy cost. Variable costs are those which vary in direct proportion to output and sales. Examples cost of labor, amount of raw materials and administrative expenses. They are not fixed cost but keep on changing with change in conditions. Semi-variable cost is fixed nature upto a certain level beyond which they vary with the firms activities. Examples are production cost, wages paid to labor can shift between variable and fixed cost. The operating leverage is the firms ability to use fixed operating costs to increase the effect of changes in sales on its earnings before interest and taxes (EBIT). Operating leverage occurs anytime a firm has fixed cost. The [percentage change in profits with a change in volume of sales is more than the percentage change in volume. An operating leverage can be favorable or unfavorable, high risks are attached to higher degrees of leverage. A larger amount of fixed expenses increases the operating risks of the company and hence a higher degree of operating leverage. Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company's cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statement. how EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statement. how earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.

Operating leverage is the name given to the impact on operating income of a change in the level of output. Financial leverage is the name given to the impact on returns of a change in the extent to which the firms assets are financed with borrowed money.