Financial Management The Measurement Metric

Question: Describe about the Financial Management for The Measurement Metric. Answer: Introduction:- Operating leverage is the measurement metric, which helps the analysts to determine the percentage of fixed expenses within the total cost of any business. It is a very crucial tool for measuring the profit margins on total revenue (Kaplan and Atkinson 2015). The management of Rammstein Holdings has selected two Australian companies for investment. The company has decided to analyze the potentialities of the two investment alternatives in respect to the cash flow degree of operating leverage. The first alternative is GUD Holdings Ltd. GUD Holdings Ltd. operates in different forms of industrial sectors. It uses to manufacture cleaning items, industrial domestic storage materials, household industrial locking products, water supply related products for both commercial domestic purposes and automotive filters. Such diversified product range has helped the organization to grow faster. The company always maintains the vision to provide long term returns to its shareholders and other investors at higher rate. The other company is Breville Group Ltd. Breville Group Ltd. is one of the popular kitchen products and appliances companies in Australia. The company manufactures and sells various types of kitchen products under the brand names, Breville and Sage. The kitched appliances are sold under the brand, Kambrook and for electrical appliances, it operates the brand, Ronson. Apart from the own brands, Breville Group is also the exclusive registered distributor of the personal care and garment care appliances of Philips Ltd. for allover Australia and New Zealand. From the product ranges, it can be concluded that the company has focused on a specific market sector. With the prosperity of the brands, the company has also gain high popularity amongst the investors for its steady income level and high return. Cash Flow Degree of Operating Leverage:- The financial performances of both the companies are analyzed by comparing the cash flow degree of operating leverages of the two companies for two years. The comparison is shown in the graph:- Comparison of the DOLs of two companies:- From the above graph, it can be stated that both the companies are involved with manufacturing processes and have to incur higher amount of fixed expenses, such as depreciation and amortization, interest at fixed rates, insurance, fixed salaries to employees etc. Hence, both the companies have maintained the cash flow degree of operational leverage above 1 over the periods. Both the companies can enjoy high profit with increase in sales, but, they have to ensure high sales volume to cover the high amount of fixed expenses (Horngren et al. 2013). However, Breville has concentrated on a particular market and GUD Holdings has diversified its main operational activities. Due to such diversifications, the DOL of GUD has been more instable than Breville over the period. Comparison of DOLs of two periods:- As discussed above, the DOLs of Breville for the two years are more or less same. It implies that the proportion of fixed expenses and variable expenses has not changed too much over the years. Thus, the level of sales volume, to pay off the fixed expense, would also not change very much accordingly (Bierman Jr and Smidt 2012). On the other hand, the DOL of GUD holdings has increased significantly rapidly in the current year. It denotes that the company has incurred higher fixed expenses in 2015 than the previous year. Thus, the level of adequate sales volume for covering the fixed expenses has also increased according to the increase of fixed expenses (Bhattacharjee et al. 2014). Usefulness of DOL in accounting and cash flow for perspective users: The degree of operating leverage can be defined as the leverage ratio which sums up the amount of operating leverage on the companys earnings before interest and tax. Operating leverage takes into the consideration the fixed cost and the proportion of variable cost in the business operations. It is worth mentioning from the financial perspective cash flow that the earnings before interest and taxes would be unpredictable for the company even though all the accounting factors remains unchanged (Lee and Park 2014). The framework largely evaluates the breakeven point of the business along with the likelihood of the profitability level of individual sales. In order to compute the company is operating leverage, the contribution margin is divided by its net operating income. It is worth mentioning that the measurement of operating leverage involves constant monitoring as because small amount of change in sales can result in the dramatic increase in profit. This enables the users of financi al information to carefully forecast the revenue as small error in forecasting can translate into large error in both net income and cash flows (Brown 2012). On the other hand, the degree of operating advantage can create a profound impact on the pricing policy as because a business firm with large operating leverage should not set the prices so low that it can never generate sufficient amount of contribution margin in order to fully offset the fixed costs. The degree of operating leverage assists the company and its decision makers to determine the most appropriate level of operating leverage to maximise the companys EBIT. A company with balanced Degree of operating leverage can provide the financial leverage with contributing factor in business profits (Damodaran 2016). Formula of Cash Flow Degree of operating leverage : DOL = Contribution Margin / Net Operating Cash Flow This ratio helps in summarising the effect after merging the financial and operating leverage and what effect such combinations and variation creates on corporate earnings. The above stated formula is helpful in assessing both the financial and the operating perspective for a potential investors (Kahl et al. 2014). Conclusion:- From the above discussion, it may be concluded that Breville Group Ltd. is a better alternative for investment in comparison to GUD Holdings Ltd. The current DOL of the company is lower than GUD Holdings and moreover, the level is also stable than that of other company. Therefore, from an investors perspective it can be stated that though Breville Ltd. cannot earn higher profits by increasing sales volume, but the problem to meet the fixed expenses in case of reduction in sales volume will be lesser in comparison to GUD Holdings. References:- Bhattacharjee, A., Higson, C. and Holly, S., 2014. Asymmetric Price Adjustment, Sticky Costs and Operating Leverage over the Business Cycle.Spatial Economics and Econometrics Centre, Heriot Watt University Bierman Jr, H. and Smidt, S., 2012.The capital budgeting decision: economic analysis of investment projects. Routledge Brown, R., 2012. Analysis of investments management of portfolios. Damodaran, A., 2016.Damodaran on valuation: security analysis for investment and corporate finance(Vol. 324). John Wiley Sons. Horngren, C.T., Sundem, G.L., Schatzberg, J.O. and Burgstahler, D., 2013.Introduction to management accounting. Pearson Higher Ed. Kahl, M., Lunn, J. and Nilsson, M., 2014, November. Operating leverage and corporate financial policies. InAFA 2012 Chicago Meetings Paper. Kaplan, R.S. and Atkinson, A.A., 2015.Advanced management accounting. PHI Learning. Lee, S. and Park, S.B., 2014. A study on the association between operating leverage and risk: The case of the airline industry.International Journal of Economics and Finance,6(3), p.120.