Question 2 (b)
Income statements from leverage data; financial position
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 2 (b) · 11 marksFrom the financial data given, prepare the income statements of Company A and Company B for the year that ended on 31st March 2017. Comment also on their financial position. 11
| Item | Company A | Company B |
|---|---|---|
| Variable expenses (% of sales) | 66.7 | 75 |
| Interest (Rupees) | 2,40,000 | 3,60,000 |
| Operating leverage (degree) | 5 | 6 |
| Financial leverage (degree) | 3 | 4 |
| Rate of income tax | 0.35 | 0.35 |
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EBIT, contribution and sales derived 4 marks 7 min
- 2 Income statements 4 marks 7 min
- 3 Combined leverage and comment 3 marks 6 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Working back from the leverages. DFL = EBIT ÷ (EBIT − interest), so EBIT = interest × DFL ÷ (DFL − 1); DOL = contribution ÷ EBIT, so contribution = EBIT × DOL; sales = contribution ÷ (1 − variable-expense ratio). The printed 66.7% is read as two-thirds.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
- Company A: EBIT = 2,40,000 × 3 ÷ 2 = 3,60,000; contribution = 3,60,000 × 5 = 18,00,000; sales = 18,00,000 ÷ (1/3) = 54,00,000.
- Company B: EBIT = 3,60,000 × 4 ÷ 3 = 4,80,000; contribution = 4,80,000 × 6 = 28,80,000; sales = 28,80,000 ÷ 0.25 = 1,15,20,000.
Income statements for the year ended 31st March 2017 (₹)
| Particulars | Company A | Company B |
|---|---|---|
| Sales | 54,00,000 | 1,15,20,000 |
| Less: variable expenses (66.7% / 75%) | 36,00,000 | 86,40,000 |
| Contribution | 18,00,000 | 28,80,000 |
| Less: fixed expenses (balancing) | 14,40,000 | 24,00,000 |
| EBIT | 3,60,000 | 4,80,000 |
| Less: interest | 2,40,000 | 3,60,000 |
| EBT | 1,20,000 | 1,20,000 |
| Less: tax @ 35% | 42,000 | 42,000 |
| EAT | 78,000 | 78,000 |
(At exactly 66.7%, Company A's sales would be 18,00,000 ÷ 0.333 = ₹54,05,405; its fixed expenses, EBIT and profit are unchanged.)
Financial position. Combined leverage = DOL × DFL: A 5 × 3 = 15; B 6 × 4 = 24. Operating leverage reflects business risk and financial leverage financial risk; the combined leverage is the % change in EPS from a 1% change in sales. Both earn ₹78,000 after tax, but Company B is in the weaker, riskier position: higher fixed costs and higher interest mean a 1% fall in sales cuts its EPS by 24%, against 15% for Company A. Each also has interest absorbing two-thirds or more of its EBIT, so neither has much cushion.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EBIT, contribution and sales derived | 4 |
| 2 | Income statements | 4 |
| 3 | Combined leverage and comment | 3 |
| Total | 11 |
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