FINA Text BK - MODULE 10 - Leverage

FINA Text BK - MODULE 10 - Leverage - MODULE 10 OPERATING...

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10: Page 1 of 31 MODULE 10 OPERATING AND FINANCIAL LEVERAGE Strap on your accounting cap because this module uses a lot of accounting values to give you insight into the way financial managers measure and use risk. Recall from Module 4 that the market measure of risk is beta because it considers the way an asset fits into a portfolio, that is, it considers correlation. This module looks at risk in isolation, that is, without considering the portfolio implications. You need to understand the risk measures here even though they are deficient when compared with beta. The reason? They are widely used and easily calculated from the company’s financial statements. The module begins with a look at breakeven analysis. It shows the way sales revenue, variable costs, and fixed costs interact to determine a company's breakeven level of operations (where net operating income is zero). Financial managers use breakeven analysis for profit planning. After you read about breakeven analysis applied to the production of only one product, I’ll show you how to expand the analysis to the production of more than one product. The module then examines the way operating and financial leverage combine to increase the exposure of investors to business and financial risk. The final part of the module considers the link between the beta of a company’s common stock and the accounting measures of risk. When you finish this module, you should be able to do the following: 1. Know the way to calculate a common-size financial statement and the reason common-size statements are useful in financial analysis. 2. Recognize the difference between fixed and variable operating costs and the way to measure a company’s contribution margin. 3. Measure the operating breakeven point for a company that produces only one product (a pure-play company) then develop a cash break-even model for a pure-play company and for a company producing more than one product. 4. Know the way to measure and use two accounting measures of risk— the degree of operating leverage and the degree of financial leverage. 5. Relate the accounting measures of risk to the market measure of risk, that is, to the beta of a company’s common stock. COMMON-SIZE FINANCIAL STATEMENTS Financial managers, investors, and security analysts use accounting numbers from financial statements to help determine the investment worth of a company. As part of the process, they usually compare the accounting numbers from one company with those of another. Example. Richard Lape of the investment firm Lape & Associates is evaluating the ability of Jenner Company to generate profit from sales. He starts out the analysis by comparing the amount of profit at Jenner Company with the level from the industry average. Jenner profit after taxes in 20x4 was $326,400. The industry average level of profit after taxes was $2,426,000. What can Mr. Lape infer about Jenner Company profitability? Answer: Jenner Company looks as though it’s performing badly, but in fact you can conclude only that its profit is less than the industry average.
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FINA Text BK - MODULE 10 - Leverage - MODULE 10 OPERATING...

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