Corporate Finance PowerPoint presentation. In this presentation, we will discuss combined leverage, get ready, it’s time to take your chance with corporate finance, combined leverage. Remember when we’re thinking about the term leverage, there’s typically two types of leverage that come into our minds. One is going to be the financial leverage the others the operating leverage the financial leverage, probably the one that pops into most people’s mind, if they’re familiar with leverage that being related to the debt in the organization and the risk and reward related to different levels of debt depending on the circumstances. And then we have the operating leverage, which has to do with the mix between the variable costs and the costs and the in the fixed costs.
They leverage, they’re being really in the fixed costs as the fixed costs increase, then we have more leverage with regards to the operating leverage both of those components, both of those things are leveraged even though they don’t seem as similar to each other, they seem like completely different things they both are leverage, because they result in a magnification of things or magnification, possibly of results of profits, for example, in good times, or magnification to off the decline or reduction in bad times. So if the circumstances are right, these two things these two leverages can magnify results, so magnification, and they can magnify the decline or the problem in the bad times. That’s why they are going to be you know, grouped together in our leverage kind of calculation. So we have the combining the operating leverage and financial leverage, that’s what we’re going to be doing with the combined leverage.
So when we put these together, we’re not talking about another category. Of course, we’re simply combining now, considering these two things are in the same category, because they have that magnifying effect. Depending on the circumstance, let’s combine them together for a combined leverage type of formula that we can then use for comparison to company to our past performance and to other companies and other industries. So you’ll recall that the operating leverage then it’s going to it has impacts acid structure of a company. For example, if we have more fixed assets, we might have higher fixed costs, which with regards to the depreciation related to the assets structure helps determine the return from operations. So what’s going to be our return on operation will depend on our operating structure, the format of our structure being in the format of cost, behavior, variable cost versus fixed costs, so we can then help determine what’s going to happen as we have different sales volumes.
If we know the behavior of our costs breaking out between their behavior, Variable And Fixed costs, the financial leverage impacts debt and equity mix. So you’ll think of our accounting equation, we have the assets that are going to be financed by liability or equity. So we’re thinking about our debt and equity mix to finance the assets. And we have helps how helps show how benefits received are allocated. So it helps us to think about how the benefits we get, such as net income from the company are going to be allocated with regards to the liability third party allocation that we might need in the in the equity in the format of our capital structure. So when we think about that, remember that we’re thinking about our accounting equation, assets equal liabilities plus equity assets are what we have in order to help us to generate revenue.
So that’s the point of us having assets, the goal of the business is revenue generation, the reason we have assets isn’t because we’re just have a pile of assets that we just want to pile up and have a nice, the biggest pile of assets, what we’re doing is putting the assets in the company in order to help generate revenue. So if we’re getting a return on the assets, then if we can maintain that return over a longer period of time, we would like to have more assets in order to maintain that return. Now, again, note that some companies they might already be at the peak, they might be basically doing fine, they don’t need any more assets. They’re a mature company, they have what they need, and they’re just pushing along forward. And if they had more assets, it wouldn’t, it may not be, they may not be positioned, that it would help you know them, they have already got the structure, the infrastructure that they need, and they’re just kind of pushing forward from this point.
If there’s a growing company, and they believe that they can, you know, generate a higher return, if they had more assets, then then they’re going to have a lot more pressure than to generate the assets they can do. So typically two ways either liabilities going up taking out debt, and as long as the generation of the assets, the income on it, the earnings on it are higher than the debt payments, which like the interest the cost of the debt, then in time in good times, then you can have pressure and it could be beneficial to magnify profits. If you were to increase debt. The other way to increase it is with equity. And equity could be the accumulation of income over time that you do not distribute back out in the form of dividends, or it can be more equity investment by the issuance of stocks. So the degree of combined leverage, then it’s going to be taken our two leverage calculations.
There’s a couple of different ways that we can calculate it. One is you can say well, we calculated the degree of operating leverage, and we calculated the degree of financial leverage, let’s just multiply those two together and we’ll get our combined leverage. Another way we can calculate it is to be taking the contribution margin. This is the total contribution margin total variable costs minus the I’m sorry, the total sales minus the total variable costs. Or we can calculate it on a per unit basis, like the sales per unit minus the cost per unit, times the unit sold divided by the earnings before taxes, which is basically the bottom line number of the income statement, whether you’re using a normal multi step income statement, or a contribution margin type of income statement, it’s basically net income before the taxes or if you have net income after the taxes, you would take that number, add back in the taxes, you’d have your net income, before the taxes, you may also see it in this format.
And note that there’s a couple ways you can write this stuff just because of the terminology that we have here. If you know that what the contribution margin is, then you can pick this up just don’t confuse contribution margin from comp to contribution margin per unit. This is not on a per unit basis, this is total sales, minus the total variable costs. And this will be a lot more clear once we work through practice problems, which we have many, and do recommend going over that one way to calculate these then would be to take the price per unit minus the variable cost per unit times the units that we would then sell. That’s one way to calculate the contribution margin. Another way to calculate it would be taking the price times the quantity, which would give us the sales and then take the the variable cost times the quantity, which would give us the total contribution to total variable cost, and then subtract total sales minus the total variable costs, same kind of calculation, the denominator then you can see includes the same calculation for the contribution margin total contribution margin here, minus the fixed costs.
So those are going to be the costs that don’t change with time and then minus the interest, which is the interest expense. And this is another way that we can get down to that earnings before taxes. The other ways you can put this denominator is to take the net income after taxes or earnings after tax is an add back the taxes, it really just depends on what data you are given. So you could see these calculations, it could be a little bit confusing to consider the fact that you could get to these numbers in a few different ways. But the better understanding you have simply what is the contribution margin, and what is the earning before taxes, the more easy it will be to get to those numbers no matter what type of data you are given. Also note that if we are working with a with a financial statement from an internal basis, then it’s more likely that we’re going to take that financial data and put it into a contribution margin type structure, which would be needed for us to be calculating the contribution margin. If we’re external to the company, then we could we we may not have the contribution margin income statement.
And we would have to estimate what the contribution margin income statement was, in order to calculate it this way. Or we can calculate the degree of operating leverage using the percent changes, and then the degree of financial leverage and multiply multiply them together. And that might be a way that would be easier from an external point of view, using financial statements that aren’t on a contribution margin type basis to get some kind of estimate that would give us a combined leverage type calculation. So we will do multiple practice problems on these leverage calculations, I highly recommend taking a look at it. The leverage calculations are something that is kind of controversial is people argue about the optimal level of leverage and what it means. So the best way to get an idea and a feel for it is to work through practice problems and just see what the shifts will be as we change some of the numbers and run through scenarios with regards to leverage