Profit Planning and Dimensions of Risk

Question 1

Operating Leverage

Answer 1

Measure of how revenue growth translates into growth in operating income.

Has to do with the mix of fixed and variable costs that the company incurs.

Question 2

Financial leverage

Answer 2

Tactic to multiply gains and losses, calculated by a debt-to-equity ratio.

Accomplished through borrowing capital on existing assets. This is really the degree to which a company uses debt and its assets to borrow to expand the business or take advantage of opportunities in the marketplace.

Question 3

Connection between revenue and costs

Answer 3

four factors impact profit

• volume of production
• price of the product
• Cost changes
• Changes in product mix

Question 4

Types of costs

Answer 4

1. Fixed Costs – expense/cost that does not change
2. Variable Costs – an expense or cost that varies
3. Semi-variable (mixed) cost – Cost composed of a mixture of both fixed and variable components

Question 5

Different cost concepts

Answer 5

1. Controllable
2. Non-controllable
3. Direct
4. Indirect
5. Committed fixed
6. Discretionary fixed

Question 6

The Contribution Margin (CM)

Answer 6

Way to examine Income Statement

Contribution Margin = Revenue – Variable Expenses
CM-fixed cost = operating profit

Question 7

High operating leverage

Answer 7

A large proportion of the company’s costs are fixed costs.

firm earns a large profit but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.

Question 8

Low operating leverage

Answer 8

A large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale.

In this case, the firm earns a smaller profit on each incremental sale but does not have to generate much sales volume in order to cover its lower fixed costs.

It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.

eg clothing retail

Question 9

Break even analysis

Answer 9

tool to understand/see what level of sales is needed to cover all of your costs.

where sales meet revenue

High Degree of Operating Leverage – High Break-Even Point (because of high relative fixed costs)
Low Degree of Operating Leverage – Low Break-Even Point

Mostly used in forecasting but can also be done on the fly to understand what to do to operations or marketing to change the level of sales in the market.

Question 10

Break-even Analysis Steps

Answer 10

1. Calculate CM
2. Calculate Fixed Costs/others you want to cover
3. Calculate breakeven point
   - Fixed amount to cover/CM% = $ revenue needed
   - Fixed amount to cover/ CM$ = number of units to sell

Question 11

Debt-Coverage Ratios

Answer 11

1. Solvency Ratio: Net income + depreciation / Short term Liabilities + Long term Liabilities
   - Interest Coverage Ratio: Operating Income (EBIT) + Interest Expense / Interest Expense
2. Debt/Total Assets – percentage of company’s assets financed by debt. Higher the ratio, greater degree of leverage.
3. Debt/Equity – degree of financial leverage being used. The higher the ratio, it implies a higher amount of debt and higher interest expense. A capital structure of equal parts debt and equity would result in a debt/equity ratio of 1. Above 1, a company has more debt; below 1, the company has more equity.

Question 12

Financial Leverage

Answer 12

The use of debt financing increases risk, but it can also increase the expected return for shareholders = using other peoples’ money!

Risk and reward