Question

The Sterling Tire Company’s income statement for 20X1 is as follows:

STERLING TIRE COMPANY
Income Statement
For the Year Ended December 31, 20X1
Sales (22,000 tires at $64 each)	$	1,408,000
Variable costs (22,000 tires at $32)		704,000
Fixed costs		420,000
Earnings before interest and taxes (EBIT)	$	284,000
Interest expense		51,000
Earnings before taxes (EBT)	$	233,000
Income tax expense (25%)		58,250
Earnings after taxes (EAT)	$	174,750

a. Compute the degree of operating leverage. (Round your answer to 2 decimal places.)
  

b. Compute the degree of financial leverage. (Round your answer to 2 decimal places.)
  

c. Compute the degree of combined leverage. (Round your answer to 2 decimal places.)
  

d. Compute the break-even point in units. (Round your answer to the nearest whole number.)
  

Answer 1

a. The degree of operating leverage is computed as follows:

= (Sales - variable cost) / EBIT

= ($ 1,408,000 - $ 704,000) / $ 284,000

= $ 704,000 / $ 284,000

= 2.48

b. The degree of financial leverage is computed as follows:

= EBIT / EBIT

= $ 284,000 / $ 233,000

= 1.22

c. The degree of combined leverage is computed as follows:

= (Sales - variable cost) / EBT

= ($ 1,408,000 - $ 704,000) / $ 233,000

= $ 704,000 / $ 233,000

= 3.02

d. The break even point is computed as follows:

= Fixed costs / (Selling price per unit - variable cost per unit)

= $ 420,000 / ($ 64 - $ 32)

= $ 420,000 / $ 32

= 13,125 units

Please ask in case of any doubts