Applying Operating and Financial Leverage in Consulting Business
Financial Leverage
In the accounting equation, A = L + OE, A is Assets, L is liabilities or debt and OE is Owner’s Equity. The use of debt (L) in a firm’s capital structure is called financial leverage. The more debt a firm has (as a percentage of assets or A), the greater is its degree of financial leverage. Debt acts as a lever in the sense that using it can greatly magnify both gains and losses.
Example: CEO of Consulting Company A decided to hire more junior consultants and after 3 months of training his plan is to put them into projects. Since the company’s cash flow is not that good to pay the training expenses and paychecks of these consultants for 3 months CFO decided to get a loan from a bank to invest in this project. The bank lent $1,000,000 loan with 10% annual interest rate. At the end of the year the EBIT of the company is $1,200,000. Annual interest $100,000 is subtracted from EBIT before income tax is calculated. After the 34% tax Net Income is $692,000. If EBIT increases by 20% the Net Income increases by 23%. This is due to financial leverage, i.e. if the company earns more, with the magnification effect of financial leverage Net Income will increase with a higher rate than the rate of increase in earnings. On the other hand if EBIT decreases by 20% this will cause a 23% decrease in Net Income.
Loan $1,000,000
Interest rate 10%
Tax rate 34%
EBIT $1,200,000
Interest $(100,000)
Tax $(408,000)
Net Income $692,000
20% increase in EBIT
EBIT $1,440,000
Interest $(100,000)
Tax $(489,600)
Net Income $850,400
40% increase in EBIT
EBIT $1,680,000
Interest $(100,000)
Tax $(571,200)
Net Income $1,008,800
60% increase in EBIT
EBIT $1,920,000
Interest $(100,000)
Tax $(652,800)
Net Income $1,167,200
Change in EBIT Change in Net Income
20% 23%
40% 46%
60% 69%
Operating Leverage
In the cost formula, TC = FC + VC, TC is Total Cost, FC is Fixed Costs and VC is Variable Costs. The ratio of fixed cost (FC) to total costs (TC) is called operating leverage. The higher a firm’s fixed costs, the higher its operating leverage, the greater the firm’s risk. Small percentage changes in sales volumes result in large percentage changes in profits.
Example: Consulting Company B has $50,000 monthly fixed cost (rental, property tax etc) and $3,000 monthly variable cost per consultant. The monthly revenue from a consultant is $12,000. So if the company can utilize 10 consultants. The Net Income will be $40,000. If the number of consultants increase by 100% up to 20 then the Net Income will be $130,000 (225% increase). This is due to the operating leverage of high fixed costs. If Fixed costs were $25,000 the net income would be $115,000 (for 10 consultants) and $205,000 (for 20 consultants), i.e. 78% increase in Net Income.
#Consultants: 10
Revenue: $120,000
VC : $(30,000)
FC : $(50,000)
NI :$40,000
#Consultants: 20
Revenue: $240,000
VC : $(60,000)
FC : $(50,000)
NI :$130,000
#Consultants: 30
Revenue: $360,000
VC : $(90,000)
FC : $(50,000)
NI :$220,000
#Consultants: 30
Revenue: $480,000
VC : $(120,000)
FC : $(50,000)
NI :$310,000
Change in #Consultants Change in Net Income
100% 225%
200% 450%
300% 675%
Bilal Ciftci, West Chester University MBA Student, PA Article Source:http://www.articlesbase.com/management-articles/applying-operating-and-financial-leverage-in-consulting-business-1772625.html
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