Unit 5.
Leverage Analysis and Working Capital Management
➢ Introduction:
Leverage refers to borrowing funds for a particular purpose with an obligation to repay these funds,
with interest, at an agreed-to schedule. The idea behind leverage is to help borrowers achieve a higher
return with a smaller investment.
You’ll want to forecast your expenditures and determine your funding requirements before deciding
what kind of leverage to use. Instruments like derivatives, where the investment is a small fraction of
the underlying position, can be used as leverage. However, in this article, we focus on debt.
If and when your business is ready to increase its scale of operations, expand into new markets, or
update existing infrastructure, you’re going to need funds. However, if you don’t have enough equity
or cash up front, you’ll have to borrow funds.
Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from lenders (debt
financing).
Equity financing involves selling your equity in exchange for funding. One of the biggest benefits of
equity financing is that it doesn’t lead to the company having to make interest payments or any
principal repayment. Some of the most common examples of equity financing are initial public
offerings (IPOs) and crowdfunding.
Debt financing involves a company borrowing money to fund working capital requirements. When a
company borrows money, it needs to make interest payments as well as repay the principal. Taking a
loan is a common debt financing example.
➢ Operating leverage
Operating leverage accounts for the fixed operating costs and variable costs of providing goods and
services. As fixed assets don’t change with the level of output produced, their costs are constant and
must be paid regardless of whether your business is making a profit or experiencing losses. On the
other hand, variable costs change depending on the output produced.
You can determine operating leverage by finding the ratio of fixed costs to variable costs. If your
business has more fixed expenses than variable expenses, it has high operating leverage. You can use
a high degree of operating leverage to magnify your returns, but too much of it can increase your
financial risk.
Business A Business B
Units sold 100,000 100,000
Price per unit $10 $10
Sales $1,000,000 $1,000,000
Variable cost per unit $6 $6
Variable cost $600,000 $600,000
Fixed charges $200,000 $50,000
Change in operating profit % $200,000 $350,000
Average cost per unit $8 $6.50
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
Business A and Business B have a similar income statement structure; the only difference is that
Business A has higher fixed costs than Business B. This implies a higher degree of operating leverage
for Business A.
Therefore, Business A has higher operating leverage than Business B.
High Demand
Business A Business B
Units sold 150,000 150,000
Price per unit $10 $10
Sales $1,500,000 $1,500,000
Variable cost per unit $6 $6
Variable cost $900,000 $900,000
Fixed charges $200,000 $50,000
Profit $400,000 $550,000
Average costs per unit $7.33 $6.33
Change in operating profit % 100% 57%
Percentage change in average cost per unit -8.33% -2.56%
When demand is high and sales increase, profits rise by a more significant percentage for Business A
than Business B. The average cost per unit also decreases by a greater amount for Business A than for
Business B.
Low Demand
Business A Business B
Units sold 75,000 75,000
Price per unit $10 $10
Sales $750,000 $750,000
Variable cost per unit $6 $6
Variable cost $450,000 $450,000
Fixed charges $200,000 $50,000
Profit $100,000 $250,000
Average costs per unit $8.67 $6.67
Change in operating profit % -50% -29%
Percentage change in average cost per unit 8.33% 2.56%
In contrast, when sales stagnate, Business A suffers more than Business B. Profits for Business A
decline more than they do for Business B, and the average cost per unit rises for Business A more than
it does for Business B.
Operating leverage can be used by businesses that have a large number of fixed assets. For example,
capital-intensive companies, such as steel production, car manufacturing, and oil extraction, can
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
leverage their fixed assets to reduce the average cost per unit and increase Earnings Before Interest
and Tax (EBIT).
➢ Financial leverage
Financial leverage refers to the amount of debt a business has acquired. On a balance sheet, financial
leverage is represented by the liabilities listed on the right-hand side of the sheet.
Financial leverage lets your business continue to make investments even if you're short on cash. It’s
usually preferred to equity financing, as it lets you raise funds without diluting your ownership.
You can determine the degree of financial leverage your business has through the debt-to-equity ratio.
This ratio represents the proportion of assets your business has compared to its shareholders’ equity.
Let’s assume your total assets for the current year are $100,000, and for the previous year, they
were $90,000. Your average total assets would then be:
(100,000 + 90,000)/2 = $95,000
You can calculate average total equity the same way.
XYZ balance sheet ($) Year ended 2021 Year ended 2020
Assets 100,000 90,000
Liabilities 30,000 5,000
Equity 70,000 85,000
A financial leverage ratio of 1 indicates no leverage. The higher the ratio, the more leveraged your
business is and the riskier your capital structure.
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
➢ Combined leverage
Combined leverage accounts for your organization’s total business risks. As the name suggests,
combined leverage aggregates the effects of operating and financial leverages to present a complete
picture of your company’s financial health.
Combined leverage can be used by capital-intensive businesses with expansion potential but
insufficient levels of cash or equity. To effectively use combined leverage though, be sure of your
business’s future expenses and the market conditions. High levels of combined risk can make returns
susceptible to inputs, such as sales volumes.
➢ Leverage disadvantages:
Leverage can magnify returns with a smaller investment, and while many investors prefer it to equity
financing, there’s no such thing as a free lunch. Too much financial leverage can drive up a business’s
risks, including:
➢ Insolvency: The more your company uses total debt, the harder it is to pay back. Banks and other
institutions often check your total leverage and financial ratios, such as debt-to-equity and interest
coverage, before agreeing to lend to you. Having too much total debt could have a risky cost structure,
and you could have difficulty raising additional funds.
➢ Higher interest payments: Long-term debt can eat into a company’s bottom line because interest is
paid from income. Also, the riskier your business seems to lenders, the higher your interest expense
and resulting cost of capital.
➢ Liquidation: Your business can lose assets or eventually declare bankruptcy if it repeatedly defaults on
payments. Banks and other lenders might seize assets like buildings and machinery if you can’t pay
back their loans.
➢ Working capital management: operating cycle
Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to their most effective use.
Current assets – It is rightly observed that “Current assets have a short life span. These type of assets
are engaged in current operation of a business and normally used for short– term operations of the
firm during an accounting period i.e. within twelve months. The two important characteristics of such
assets are, (i) short life span, and (ii) swift transformation into other form of assets. Cash balance may
be held idle for a week or two; account receivable may have a life span of 30 to 60 days, and
inventories may be held for 30 to 100 days.
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
Current liabilities – The firm creates a Current Liability towards creditors (sellers) from whom it has
purchased raw materials on credit. This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors. The claims or obligations which are
normally expected to mature for payment within an accounting cycle (1 year) are known as current
liabilities. These can be defined as “those liabilities where liquidation is reasonably expected to require
the use of existing resources properly classifiable as current assets, or the creation of other current
assets, or the creation of other current liabilities.”
The efficiency of working capital management can be quantified using ratio analysis.
Companies may rely on the working capital cycle when managing working capital. Working capital
management helps maintain the smooth operation of the net operating cycle, also known as the cash
conversion cycle (CCC)—the minimum amount of time required to convert net current assets and
liabilities into cash. The working capital cycle is a measure of the time it takes for a company to convert
its current assets into cash, or:
Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle - Payable Cycle
The working capital cycle represents the period measured in days from the time when the company
pays for raw materials or inventory to the time when it receives payment for the products or services
it sells. During this period, the company's resources may be tied up in obligations or pending
liquidation to cash.
Inventory Cycle
The inventory cycle represents the time it takes for a company to acquire raw materials or inventory,
convert them into finished goods, and store them until they are sold. During this stage, the company's
cash is tied up in inventory. Though it starts the cycle with cash on hand, the company agrees to part
ways with working capital with the expectation that it will receive more working capital in the future
by selling the product at a profit.
Accounts Receivable Cycle
The accounts receivable cycle represents the time it takes for a company to collect payment from its
customers after it has sold goods or services. During this stage, the company's cash is tied up in
accounts receivable. Though the company was able to part ways with its inventory, it's working capital
is now tied up in accounts receivable and still does not give the company access to capital until these
credit sales are received.
Accounts Payable Cycle
The accounts payable cycle represents the time it takes for a company to pay its suppliers for goods
or services received. During this stage, the company's cash is tied up in accounts payable. On the
positive side, this represents a short-term loan from a supplier meaning the company is able to hold
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
onto cash even though they have received a good. On the negative side, this creates a liability that
needs to be managed.
Working Capital Cycle OR Operating cycle OR Cash Conversion Cycle:
Working capital requirement depends upon the operating cycle of the business. The operating cycle
or working capital cycle of a business starts with the acquisition of raw materials and ends with the
collection of receivables from sale proceeds.
The Operating cycle of a business determines its working capital requirement. The Total time period
involved in an operating cycle is the sum total of time taken to carry out two important steps i.e.
Inventory conversion Period - Total time taken in production and sale of products.
Debtors conversion Period - Total time taken to collect the outstanding amount from customers.
The Operating cycle includes the following stages-
1. Raw material and storage stage (R)
2. Work in Progress stage (W)
3. Finished Goods stage (F)
4. Collection of Receivables and Debtors Collection (D)
5. Payment to Creditors (C)
Operating Cycle of a Business
Gross Operating Cycle = R + W+ F+ D
The Net operating cycle represents cash conversion cycle.
Net Operating Cycle = R + W+ F+ D- C
Increase in operating cycle =
Difference in time taken for debt collection + Difference in time taken in credit payments
Less
Difference in finished goods + Difference in stock of Raw material
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
➢ Determinants of working capital
i. Nature of Business - In small trading businesses, the initial investment on fixed assets is low and the
working capital requirements are high, whereas big Trading houses incur more investment on initial
fixed capital than working capital.
ii. Size of Business - By virtue of its size a large business with wide range of activities require more
working capital than a small business.
iii. Production Cycle - In case of continuous production Working Capital requirements will be high and
low in case of intermitted production.
iv. Business Cycle - WC requirements are high in boom period and less at the time of depression in
the economy.
v. Production Policy - If the company has the policy to stop/reduce production during slack periods
and fluctuations their working capital requirement is low but if it continues production at full scale
even in slack season it will incur a high working capital.
vi. Credit Policy - If the company purchases Raw material on credit basis and sells finished goods on
cash basis, it will have low working capital requirements but in the reverse scenario working capital
requirements will be high.
vii. Availability of Raw Materials - If raw material is readily available the company will have a low
working capital, but if the raw material is scarce, the company will incur a high working capital.
viii. Earning Capacity - Firms with high earning capacities are able to earn more cash profits that can
be contributed towards working capital requirements, while firms with less earning capacity will have
a high working capital.
ix. Level of Taxes - High level of taxes indicate a high Working capital while low level of taxes indicate
a low working capital as taxes cut down profits of companies which in turn focus on higher productivity
and high sales of products which require a high working capital.
x. Nature of Demand - If the demand for the company's product is high it will incur a high working
capital, but if the demand for the company's product is low it will incur less working capital.
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
OR
1. Nature of Companies: The composition of an asset is a function of the size of a business and the
companies to which it belongs. Small companies have smaller proportions of cash, receivables and
inventory than large corporation. This difference becomes more marked in large corporations. A public
utility, for example, mostly employs fixed assets in its operations, while a merchandising department
depends generally on inventory and receivable. Needs for working capital are thus determined by the
nature of an enterprise.
2. Demand of Creditors: Creditors are interested in the security of loans. They want their obligations
to be sufficiently covered. They want the amount of security in assets which are greater than the
liability.
3. Cash Requirements: Cash is one of the current assets which are essential for the successful
operations of the production cycle. A minimum level of cash is always required to keep the operations
going. Adequate cash is also required to maintain good credit relation.
4. Nature and Size of Business: The working capital requirements of a firm are basically influenced by
the nature of its business. Trading and financial firms have a very less investment in fixed assets, but
require a large sum of money to be invested in working capital. Retail stores, for example, must carry
large stocks of a variety of goods to satisfy the varied and continues demand of their customers. Some
manufacturing business, such as tobacco manufacturing and construction firms also have to invest
substantially in working capital and a nominal amount in the fixed assets.
5. Time: The level of working capital depends upon the time required to manufacturing goods. If the
time is longer, the size of working capital is great. Moreover, the amount of working capital depends
upon inventory turnover and the unit cost of the goods that are sold. The greater this cost, the bigger
is the amount of working capital.
6. Volume of Sales: This is the most important factor affecting the size and components of working
capital. A firm maintains current assets because they are needed to support the operational activities
which result in sales. They volume of sales and the size of the working capital are directly related to
each other. As the volume of sales increase, there is an increase in the investment of working capital-
in the cost of operations, in inventories and receivables.
7. Terms of Purchases and Sales: If the credit terms of purchases are more favourable and those of
sales liberal, less cash will be invested in inventory. With more favourable credit terms, working capital
requirements can be reduced. A firm gets more time for payment to creditors or suppliers. A firm
which enjoys greater credit with banks needs less working capital.
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
8. Business Cycle: Business expands during periods of prosperity and declines during the period of
depression. Consequently, more working capital required during periods of prosperity and less during
the periods of depression.
9. Production Cycle: The time taken to convert raw materials into finished products is referred to as
the production cycle or operating cycle. The longer the production cycle, the greater is the
requirements of the working capital. An utmost care should be taken to shorten the period of the
production cycle in order to minimize working capital requirements.
10. Liquidity and Profitability: If a firm desires to take a greater risk for bigger gains or losses, it
reduces the size of its working capital in relation to its sales. If it is interested in improving its liquidity,
it increase the level of its working capital. However, this policy is likely to result in a reduction of the
sales volume, and therefore, of profitability. A firm, therefore, should choose between liquidity and
profitability and decide about its working capital requirements accordingly.
11. Seasonal Fluctuations: Seasonal fluctuations in sales affect the level of variable working capital.
Often, the demand for products may be of a seasonal nature. Yet inventories have got to be purchased
during certain seasons only. The size of the working capital in one period may, therefore, be bigger
than that in another.
➢ Types of working capital
In its simplest form, working capital is just the difference between current assets and current liabilities.
However, there are many different types of working capital that each may be important to a company
to best understand its short-term needs.
Permanent Working Capital: Permanent working capital is the amount of resources the company will
always need to operate its business without interruption. This is the minimum amount of short-term
resources vital to operations.
Regular Working Capital: Regular working capital is a component of permanent working capital. It is
the part of the permanent working capital that is actually required for day-to-day operations and
makes up the "most important" part of permanent working capital.
Reserve Working Capital: Reserve working capital is the other component of permanent working
capital. Companies may require an additional amount of working capital on hand for emergencies,
seasonality, or unpredictable events.
Fluctuating Working Capital: Companies may be interested in only knowing what their variable
working capital is. For example, companies may opt into paying for inventory as it is a variable cost.
However, the company may have a monthly liability relating to insurance it does not have the option
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
to decline. Fluctuating working capital only considers the variable liabilities the company has complete
control over.
Gross Working Capital: Gross working capital is simply the total amount of current assets of a business
before considering any short-term liabilities. Gross working capital refers to total investment in
current assets. The current assets employed in business give the idea about the utilization of working
capital and idea about the economic position of the company. Gross working capital concepts is
popular and acceptable concept in the field of finance.
Net Working Capital: Net working capital is the difference between current assets and current
liabilities. Net working capital means current assets minus current liabilities. The difference between
current assets and current liabilities is called the net working capital. If the net working capital is
positive, business is able to meet its current liabilities. Net working capital concept provides the
measurement for determining the creditworthiness of company.
➢ Importance of working capital
#1 – Liquidity Management: By properly analyzing the income, expenses and payables, the financial
and accounting team of an enterprise can easily plan for their funds accordingly.
#2 – Out of Cash: Inappropriate management of day to day expenses may result in enterprise liquidity
issues. Therefore, the planned management of working capital can avoid such a situation.
#3 – Helps in Decision Making: By correctly analyzing the requirement of funds for day to day
operations, the finance team can appropriately manage the funds and can decide on available funds
and the needed funds.
#4 – Addition in the Value of Business: Proper working capital management results in timely payment
to the lenders, which creates goodwill in the market.
#5 – Helps in the Situation of Cash Crunches: By properly managing the liquid funds, one can help the
organization avert any cash crunch and pay for its day to day expenses on a timely basis.
#6 – Perfect Investments Plans: Correctly managing the funds or working capital, the company can
plan for their investments accordingly and maximize its return.
#7 – Helps in Earning Short Term Profits: Some enterprises keep a large buffer of funds as working
capital, which is way over and above the required level of working capital. By correctly estimating the
required working capital, the extra funds can be invested in other projects that may result in higher
profits.
#8 – Strengthening the Work Culture of the Entity: Timely payment of all day to day expenses like the
salary of the employees creates a good environment and motivates employees to work harder.
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
➢ Components of working capital
Certain balance sheet accounts are more important when considering working capital management.
Though working capital often entails comparing all current assets to current liabilities, there are a few
accounts more critical to track.
Cash: The core of working capital management is tracking cash and cash needs. This involves managing
the company's cash flow by forecasting needs, monitoring cash balances, and optimizing cash inflows
and outflows to ensure that the company has enough cash to meet its obligations. Because cash is
always considered a current asset, all accounts should be considered. However, companies should be
mindful of restricted or time-bound deposits.
Receivables: To manage capital, companies must be mindful of their receives. This is especially
important in the short-term as they wait for credit sales to be completed. This involves managing the
company's credit policies, monitoring customer payments, and improving collection practices. At the
end of the day, having completed a sale does not matter if the company is unable to collect payment
on the sale.
Payables: Payables in one aspect of working capital management that companies can take advantage
of that they often have greater control over. While other aspects of working capital management may
be out of the company's hands (i.e. selling goods or collecting receivables), companies often have a
say in how they pay suppliers, what the credit terms are, and when cash outlays are made.
Inventory: Companies primary consider inventory during working capital management as it may be
most risky aspect of managing capital. When inventory is sold, a company must go to the market and
rely on consumer preferences to convert inventory to cash. If this cannot be completed in a timely
manner, the company may be forced to have short-term resource stuck in an illiquid position.
Alternatively, the company may be able to quickly sell the inventory but only with a steep price
discount.
➢ Measuring working capital requirements
The Working Capital Requirement of a business is the sum of current assets or the amount of funds
necessary to cover the cost of operating expenses of the business.
The two main components of working capital are current assets and current liabilities. The excess of
current assets over current liabilities is known as working capital.
Working Capital = Current Assets - Current Liabilities
It is simply the cash required for purchase of raw materials and their conversion into finished products.
Gross Working Capital - It is the capital invested in total current assets.
Net Working Capital - It is the excess of current assets over current liability
SH481U Accounts and Finance for Entrepreneurs
Unit 5. Leverage Analysis and Working Capital Management
➢ Basic problems on working capital
SH481U Accounts and Finance for Entrepreneurs