The correct answer is: A. EBIT ÷ Contribution
Financial leverage is a measure of how much a company uses debt to finance its assets. A high degree of financial leverage means that a company has a lot of debt, and a low degree of financial leverage means that a company has very little debt.
The formula for calculating financial leverage is:
Financial leverage = EBIT ÷ Contribution
Where:
- EBIT = Earnings before interest and taxes
- Contribution = Sales – Variable costs
Financial leverage is a useful tool for companies that are trying to grow their business. By using debt to finance their assets, companies can increase their return on equity (ROE). However, financial leverage also increases a company’s risk. If a company’s sales decline, it may not be able to make its interest payments, which could lead to bankruptcy.
Therefore, companies need to carefully consider their financial leverage before taking on debt. They need to make sure that they can afford the interest payments and that they have a plan in place for what they will do if their sales decline.
Here is a brief explanation of each option:
- Option A: EBIT ÷ Contribution. This is the correct answer. EBIT is earnings before interest and taxes, and contribution is sales minus variable costs. This is the most common way to calculate financial leverage.
- Option B: EBIT ÷ PBT. This is not the correct answer. PBT is profit before tax. It is calculated by taking EBIT and subtracting taxes. Financial leverage is not affected by taxes.
- Option C: EBIT ÷ Sales. This is not the correct answer. Sales is the total amount of revenue that a company generates. Financial leverage is not affected by sales.
- Option D: EBIT ÷ Variable Cost. This is not the correct answer. Variable cost is the cost of goods sold that changes with the volume of production. Financial leverage is not affected by variable costs.