Leverage to Profit

Abstract

This article describes how to use the degree of total leverage (DTL) to forecast earnings. Although both DTL and forecasted earnings are accounting constructs, they get covered under different fields of accounting in the MBA curriculum. DTL is a useful concept in Cost, Volume, and Profit (CVP) analysis, which is covered in Managerial Accounting. Forecasting of earnings is an essential outcome of Financial Statement Analysis, and forecasted earnings are an integral input in valuation. Often, the learnings from managerial accounting are kept aside while doing financial statement analysis, generating earnings forecast, and valuing a firm, which happens because of a lack of exposure to how various fields of accounting are related. This short article aims to bridge this gap and remind forecasters how they can use the CVP analysis insights in forecasting profits. An essential assumption of CVP analysis is that only the quantity of output can change in the short run. Thus, total fixed costs would remain the same within a relevant range, whereas variables costs would change as output quantity changes. This assumption allows us to plot the amount of revenue, cost, and profit (on the y-axis) for various levels of sales quantity (on the x-axis). In this graph, the slope of the profit line is constant and represents contribution per unit. The concept of contribution is fundamental to CVP analysis and represents the amount provided by sales (after paying for variable costs) to cover the fixed costs of a firm. When contribution and fixed costs (both operating and financial) are equal, the firm breaks even. When the contribution is less than the fixed costs, the firm has incurred a loss. By contrast, when the contribution exceeds the fixed costs, a firm generates a profit (before taxes). It is mainly the operating and financial fixed costs and non-operating incomes that separates profit from contribution. The higher the total fixed cost, the lower is the profit holding everything else constant. A firm’s business model and its operating, investing, and financial decisions affect fixed costs.