Chapter 05: Operating and Financial Leverage
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Ryan Boot Company (review of Chapters 2 through 5) (multiple LO’s from Chapters 2
through 5)
RYAN BOOT COMPANY
Balance Sheet
December 31, 20X1
Assets Liabilities and Stockholders’ Equity
Cash……………………………………. $ 50,000 Accounts payable………………. $2,200,000
Marketable securities……………. 80,000 Accrued expenses………………. 150,000
Accounts receivable……………… 3,000,000 Notes payable (current)………. 400,000
Inventory…………………………….. 1,000,000 Bonds (10%)…………………….. 2,500,000
Gross plant and equipment
Less………………………………….
6,000,00 Common stock (1.7 million
shares, par value $1)…………
1,700,000
Accumulated depreciation… 2,000,00
0
Retained earnings………………. 1,180,000
Total assets…………………………..
$8,130,00
0
Total liabilities and
stockholders’ equity…………
$8,130,000
Income Statement—20X1
Sates (credit)…………………………………………………………………. $7,000,000
Fixed costs*………………………………………………………………….. 2,100,000
Variable costs (0.60)………………………………………………………. 4,200,000
Earnings before interest and taxes……………………………………. 700,000
Less: Interest……………………………………………………………… 250,000
Earnings before taxes…………………………………………………….. 450,000
Less: Taxes @ 35%…………………………………………………….. 157,500
Earnings after taxes……………………………………………………….. $ 292,500
Dividends (40% payout)………………………………………………. 117,000
Increased retained earnings…………………………………………….. $ 175,500
*Fixed costs include (a) lease expense of $200,000 and (b) depreciation of
$500,000.
Note: Ryan Boots also has $65,000 per year in sinking fund obligations
associated with its bond issue. The sinking fund represents an annual repayment
of the principal amount of the bond. It is not tax-deductible.
Comprehensive Problem 1 (Continued)
Ratios
Ryan Boot Industry
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Chapter 05: Operating and Financial Leverage
(to be filled in)
Profit margin…………………………….. _____________ 5.75%
Return on assets…………………………. _____________ 6.90%
Return on equity………………………… _____________ 9.20%
Receivables turnover………………….. _____________ 4.35X
Inventory turnover……………………… _____________ 6.50X
Fixed-asset turnover…………………… _____________ 1.85X
Total-asset turnover……………………. _____________ 1.20X
Current ratio……………………………… _____________ 1.45X
Quick ratio………………………………… _____________ 1.10X
Debt to total assets……………………… _____________ 25.05%
Interest coverage……………………….. _____________ 5.35X
Fixed charge coverage………………… _____________ 4.62X
a. Analyze Ryan Boot Company, using ratio analysis. Compute the ratios on the prior
page for Ryan and compare them to the industry data that is given. Discuss the weak
points, strong points, and what you think should be done to improve the company’s
performance.
b. In your analysis, calculate the overall break-even point in sales dollars and the cash
break-even point. Also compute the degree of operating leverage, degree of financial
leverage, and degree of combined leverage. (Use footnote 2 for DOL and footnote 3
in the chapter for DCL.)
c. Use the information in parts a and b to discuss the risk associated with this company.
Given the risk, decide whether a bank should lend funds to Ryan Boot.
Ryan Boot Company is trying to plan the funds needed for 20X2. The management
anticipates an increase in sales of 20 percent, which can be absorbed without increasing
fixed assets.
d. What would be Ryan’s needs for external funds based on the current balance sheet?
Compute RNF (required new funds). Notes payable (current) and bonds are not part
of the liability calculation.
e. What would be the required new funds if the company brings its ratios into line with
the industry average during 20X2? Specifically examine receivables turnover,
inventory turnover, and the profit margin. Use the new values to recompute the
factors in RNF (assume liabilities stay the same).
f. Do not calculate, only comment on these questions. How would required new funds
change if the company
(1) Were at full capacity?
(2) Raised the dividend payout ratio?
(3) Suffered a decreased growth in sales?
(4) Faced an accelerated inflation rate?
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Chapter 05: Operating and Financial Leverage
CP 5-1. Solution:
Ryan Boot Company
a. Ratio analysis Ryan Industry
Profit margin $292,500/$7,000,000 4.18% 5.75%
Return on assets
$292,500/$8,130,000
3.60%
6.90%
Return on equity
$292,500/$2,880,000
10.16%
9.20%
Receivable turnover
$7,000,000/$3,000,000
2.33x
4.35x
Inventory turnover
$7,000,000/$1,000,000
7.00x
6.50x
Fixed asset turnover
$7,000,000/$4,000,000
1.75x
1.85x
Total asset turnover
$7,000,000/$8,130,000
.86x
1.20x
Current ratio
$4,130,000/$2,750,000
1.50x
1.45x
Quick ratio
$3,130,000/$2,750,000
1.14x
l.l0x
Debt to total assets
$5,250,000/$8,130,000
64.58
25.05
Interest coverage
$700,000/$250,000
2.80x
5.35x
Fixed charge coverage See calculation below* 1.64x 4.62x
$700,000+200,000(Lease)
* 1.64x
$250,000 200,000 65,000 / (1 .35) =
+ + –
Lease expense of $200,000 and sinking fund of $65,000
a. The company has a lower profit margin than the industry and
the problem is further compounded by the slow turnover of
assets (.86x versus an industry norm of 1.20x). This leads to
The slow turnover of assets can be directly traced to the
unusually high level of accounts receivable. The firm’s
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Chapter 05: Operating and Financial Leverage
accounts receivable turnover ratio is only 2.33x, versus an
The previously mentioned heavy debt position becomes more
b. Break-even in sales
Sales Fixed costs Variable costs= +
(variable costs are expressed as a percentage of sales)
BE
Sales $2,100,000 .60 Sales
.40 S $2,100,000
S $2,100,000 / .40
S $5,250,000
= +
=
=
=
Cash break-even
BE
BE
Sales ($2,100,000 $500,000) + .60 Sales
Sales $1,600,000 .60 Sales
.40 $1,600,000
$1,600,000 / .40
$4,000,000
S
S
S
= –
= +
=
=
=
*Depreciation
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Chapter 05: Operating and Financial Leverage
TVC
DOL TVC FC
$7,000,000 $4,200,000
$7,000,000 $4,200,000 $2,100,000
$2,800,000 4x
$700,000
S
S
–
=– –
–
=– –
= =
EBIT $700,000
DFL EBIT $700,000 $250,000
$700,000 1.56x
$450,000
I
= =
– –
= =
TVC
DCL TVC FC
$7,000,000 $4,200,000
$7,000,000 $4,200,000 $2,100,000 $250,000
$2,800,000 6.22x
$450,000
S
S I
–
=– – –
–
=– – –
= =
c. Ryan is operating at a sales volume that is $1,750,000 above
the traditional break-even point and $3,000,000 above the
cash break-even point. This can be viewed as somewhat
positive.
However, the firm has a high degree of leverage, which
indicates any reduction in sales volume could have a very
Chapter 05: Operating and Financial Leverage
The banker would have to question the potential use of the
funds and the firm’s ability to pay back the loan. Actually, the
One possible use of the funds might be to pay off part of the
current notes payable of $400,000. This might be acceptable
if the firm can demonstrate the ability to meet its future
d.
( ) ( ) ( )
2
A L
Required new funds = S S PS 1 D
S S
D – D – –
( ) ( )
( )
Change in Sales = 20% $7,000,000= $1,400,000
$4,130,000 $2,350,000
RNF $1,400,000 $1,400,000
$7,000,000 $7,000,000
4.18% $8,400,000 (1 .4)
´
= –
– –
( ) ( ) ( )
RNF = .590 $1,400,000 .336 $1,400,000 $351,120 .6
$826,000 $470,400 $210,672
$144,928
– –
= – –
=
Chapter 05: Operating and Financial Leverage
Receivables = Sales/Receivable turnover
Chapter 05: Operating and Financial Leverage
(3) Fewer funds would be required as sales grow less rapidly.
(4) As inflation increased, so would the cost of new assets,
especially inventory and plant and equipment. Even if
sales prices could be increased, more assets would be
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of McGraw-Hill Education.