Following is the most recent income statement for Ironworks Railroad. Ironworks

Question

Following is the most recent income statement for Ironworks Railroad. Ironworks has no prepared stock.

Sales                                                              $200,000
Variable Operating Costs                               (140,000)
Gross profit                                                      60,000
Fixed operating costs                                     (40,000)
Net operating income (EBIT)                           20,000
Interest expense                                            (10,000)
Taxable Income                                                10,000
Taxes 40%                                                         (4,000)
Net Income                                                       6,000

a. What is Ironworks' degree of operating leverage (DOL)?

b. What is Ironworks' degree of Financial leverage   (DFL)?

c. What is Ironworks' degree of total leverage         (DTL)?

Explanation / Answer

a) The formula for calculating the Degree of Operating leverage is We know that Sales - Variable costs = Contribution margin. Here Gross profit is assumed as Contribution margin. DOL = Contribution margin / Net operating income          = $60,000 / $20,000          = 3 times Therefore, the Degree of Operating leverage is 3 b) The formula for calculating the Degree of Financial leverage is DFL = EBIT / (EBIT - I)                         where I is the interest expense         = $20,000 / ($20,000 - $10,000)         = $20,000 / $10,000         = 2 times Therefore, the Degree of Financial leverage is 2 times c) The formula for calculating the Total leverage is Total leverage = Degree of Operating leverage * Degree of Financial leverage                        = 3 * 2                        = 6 Therefore, the degree of total leverage or combined leverage is 6

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