Question 5 OR
Short notes: EBIT-EPS analysis, operating versus financial leverage, cash budget
15 marks
- Time to write
- About 30 minutes
From an older CBCS paper
Question
Question 5 OR · 15 marksWrite short notes on any three of these:
ABC analysis in inventory management.
EBIT-EPS Analysis.
EOQ Model
The Difference between Operating and Financial Leverage.
Cash Budget.
Reworded from the university paper; 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
Read from the question
- any threeAnswer any 3 of the 5, 5 marks each. Only 3 are marked: a fourth earns nothing.
- Difference betweenSet the differences out in a table, basis by basis, not as two separate essays.
- short notesA note opens with the meaning, then two or three key points. No long introduction.
What the paper leaves open
Any three of the five. Options (i) ABC analysis and (iii) EOQ model are outside the current syllabus; the answer writes notes on (ii), (iv) and (v).
Write it in this order
The parts stand alone: start with the one you are surest of.
- Read; underline the asks; jot your points 2 min
- 1 (ii) EBIT-EPS Analysis 5 marks 9 min
- 2 (iv) The Difference between Operating and Financial Leverage 5 marks 9 min
- 3 (v) Cash Budget 5 marks 8 min
- Check: every ask answered, key terms underlined 2 min
Easy marks
- Choose the ones you know best: each carries the same marks.
Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.
Try it first. About 30 minutes for 15 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.
Options (i), ABC analysis, and (iii), the EOQ model, are outside the current syllabus (paper note); notes are written on (ii), (iv) and (v).
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.
(ii) EBIT-EPS Analysis
Meaning. The analysis of the effect of different patterns of financing, i.e. of financial leverage, on the returns available to shareholders under different assumed levels of EBIT is EBIT-EPS analysis. The financing pattern does not affect sales or EBIT, which depend on investment decisions; but for a given EBIT each financing mix gives a different EPS.
Method. For each plan, EPS = (EBIT − I)(1 − t) − preference dividend, ÷ number of equity shares, computed at the expected EBIT and over a range of EBIT levels. Example: EBIT ₹3,00,000, tax 30%. Plan A: 30,000 shares, no debt: EPS = 2,10,000 ÷ 30,000 = ₹7. Plan B: 20,000 shares and ₹10 lakh of 10% debt: EPS = 1,40,000 ÷ 20,000 = ₹7. Here ₹3,00,000 is the indifference point; above it plan B gives the higher EPS, below it plan A.
Uses and limits. It identifies the financial break-even point (EBIT just covering fixed financial charges), the indifference point between plans, and the plan that maximises EPS at the expected EBIT. But it ignores risk (higher leverage makes EPS more volatile) and the effect of leverage on the share price, so the plan with the highest EPS is not necessarily the best.
(iv) The Difference between Operating and Financial Leverage
| Point | Operating leverage | Financial leverage |
|---|---|---|
| Relationship | Sales and EBIT | EBIT and EPS (or EBT) |
| Cause | Fixed operating costs | Fixed financial charges (interest, preference dividend) |
| Measure | DOL = contribution ÷ EBIT | DFL = EBIT ÷ EBT, with no preference dividend; with a preference dividend Dp, DFL = EBIT ÷ [EBT − Dp ÷ (1 − t)] |
| Risk measured | Business (operating) risk | Financial risk |
| Side of the balance sheet | Asset side: depends on the cost structure | Liabilities side: depends on the capital structure |
| Under management's control | Determined largely by technology and the nature of the business | Chosen through the financing decision |
| Favourable when | Sales are above the operating break-even point | Return on assets exceeds the cost of debt (trading on equity) |
Both magnify changes; their product, the combined leverage, measures the % change in EPS for a 1% change in sales. A firm with high operating leverage usually keeps financial leverage low, and vice versa, so that total risk stays manageable.
(v) Cash Budget
Meaning. A cash budget is an estimate of cash receipts and disbursements during a future period of time: an analysis of the flow of cash in a business over a future short or long period, a forecast of expected cash intake and outlay. It is the most important device for the control of receipts and payments of cash.
Purpose. It shows in advance when the firm will have a shortage of cash (so that a bank overdraft or short-term loan can be arranged in time) and when it will have a surplus (so that it can be invested productively for short periods). It is the most important tool for determining the optimal cash balance.
Preparation (receipts and payments method). For each month (or other period):
| Particulars | |
|---|---|
| Opening cash balance | from the previous period |
| Add: receipts | cash sales, collections from debtors (allowing for the credit period), other income, sale of assets, new capital or loans |
| Less: payments | cash purchases, payments to creditors, wages, expenses (allowing for lags), capital expenditure, interest, tax, dividends |
| Closing cash balance | opening + receipts − payments; carried forward |
Comparing the closing balance with the minimum balance required shows the finance needed or the surplus available.
Kinds. Short-term budgets (weekly or monthly, for day-to-day control) and long-term forecasts (three or more years, for working capital and capital projects).
Limitations. It rests on forecasts of sales and collections, which can go wrong; it needs regular revision.
Where the 15 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | (ii) EBIT-EPS Analysis | 5 |
| 2 | (iv) The Difference between Operating and Financial Leverage | 5 |
| 3 | (v) Cash Budget | 5 |
| Total | 15 |
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