Financial Management: Operating Leverage, ROE, and Financial Leverage

This article discusses the computation of operating leverage, ROE, and financial leverage in financial management. It also compares and analyzes the findings of two companies. The role of corporate governance and finance manager is also discussed.

Running head: FINANCIAL MANAGEMENT
Financial Management
Name of the Student:
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Author’s Note:

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Table of Contents
Part A...............................................................................................................................................2
Computation of Operating Leverage...........................................................................................2
Computation of ROE...................................................................................................................2
Computation of the Financial Leverage......................................................................................3
Comparisons and Findings..........................................................................................................3
Part B...............................................................................................................................................4
Reference.........................................................................................................................................7

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Part A
Computation of Operating Leverage
Particulars 2016 2017 2016 2017
Sales 10.7 11.6 13.9 14.6
EBIT 5.7 6.2 7.4 8.1
Change in Sales
Change in EBIT
Operating Leverage
Company A Company B
1.04 1.88
8.41%
8.77%
5.04%
9.46%
As per the above table which shows the operating leverage computation. Operating
leverage shows the measure of the fixed and variable costs which are incurred on a project
(Axelson et al. 2013). As per the above calculations, the operating leverage of Company B is
higher which is shown to be 1.88 and the operating leverage of Company A is shown to be 1.04.
Computation of ROE
Particulars Company A Company B
EBIT 5.7 7.4
Less: Interest 0.6 1
Cash to Equity 5.1 6.4
Equity 4.9 6.3
ROE 104% 102%

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Computation of the Financial Leverage
Particulars Company A Company B
Return on Assets 10% 20%
Interest 0.6 1
Debt 5.8 9.3
Cost of Debt 10.34% 10.75%
Financial Leverage Gain/(Loss) -0.345% 9.247%
The financial leverage shows the amount of debts or borrowings which the business has
taken for purpose of conducting day to day activities of the business (Obradovich and Gill 2013).
The financial leverage of Company B is significantly more than the financial leverage of
Company A. The financial leverage of Company B is shown to be 9.247%.
Comparisons and Findings
As per the operating leverage which is calculated above shows that Company A has a low
operating leverage as compared to Company B. This implies that the Company B has high fixed
costs and variable costs for the product and therefore the business has to depend on the sales
volume to cover the high fixed costs expenses of the business (Rehman 2013). Whereas
Company B has low operating leverage which shows that the company has low fixed cost and is
more favorable condition as compared to Company A which faces significant operating risks.
In case of the ROE, Company A has more ROE as compared to Company B which
signifies that Company A is able to meet the needs of the shareholders effective in comparison to
Company B. ROE is considered to be a financial indicator of the overall success of the business

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and therefore it can be said that Company A which has an ROE of 104% is more successful
(Kijewska 2016).
The financial leverage reveals that Company B has a high financial ratio while company
A has a negative financial ratio. The high financial ratio of Company B suggest that the company
has taken significant amount of debt in the capital structure of the business for operation of
business. However, such excess financial leverage ratio increases the risk of business failures
which the business might face. On the other hand, Company B does not have any debts as per the
financial leverage as the estimate is shown to be negative.
Thus, on the basis of overall estimate and analysis Company A is more favorable than
Company B, however Company A needs to employ some debt in the business so as to take
advantage of the same and bring about some stability in the business.
Part B
Corporate Governance can be defined as the set of rules and practices which are followed
by companies so as to ensure that there is accountability, fairness and transparency in the
approach of the company (Tricker and Tricker 2015). Corporate Governance deals with the
policies which are formulated by businesses for the purposes of governing and monitoring the
activities of the business. The main focus of corporate governance is to increase the
accountability of the business and also promote ethical behavior in the organization (McCaher,
Sautner and Starks 2016).
The most important role which corporate governance plays in the business is that its helps
in formulation of strategies, principles and ethical norms which are to be followed by the
business so as to promote transparency and accountability of the business. Research which have

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been conducted shows that a business which effective follows corporate governance principles
are often rewarded with high market share valuations. In a public business, the level of control
and transparency which is required can be effectively provided by corporate governance
principles.
The role of finance manager is quite crucial in the overall corporate governance of the
business. The finance manager needs to ensure that the business is following corporate
governance principles so as prevent any unethical conduct which might occur in the business.
The finance manager reviews the financial records of the business and therefore can detect any
misrepresentation in the financial statements of the business effectively. In addition to this, the
finance manager is also involved in the planning process and goals setting process of the
business (Armstrong et al. 2015). Therefore, the finance manager can ensure that the policies of
the business are directed towards sustainable development and wealth maximization principle for
the stakeholders of the business. The finance manager is also responsible for supervising the
performance of the business and also keep a track of the performance of the business on the basis
of financial data which is available.
The finance manager can ensure that wealth maximization principle which states that the
objective of the business should be wealth maximization of the shareholders of the business and
at the same time review whether the financial performance of the business is business is
appropriate or nor. In addition to corporate governance is used in many businesses to measure
the risks which the business faces and minimize the same which is done by different strategies
which are formulated by the finance manager of the business. In addition to this, the finance
manager and also the board of directors of the business primary focus should to meet the needs
of the stakeholders of the business (Bushee, Carter and Gerakos 2013). The stakeholders of the

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business comprise of shareholders, employees, suppliers and customers and the general society at
large. The stakeholders of the company expect the business to act ethically and look after the
needs of the society at large and also follow the wealth maximization policy of the business.
Thus, it can be concluded that the corporate governance policy which is followed by
every business is essential for the business to maintain its integrity in the eyes of the society and
also act in an ethical manner. The role of finance manager is also crucial as he can effectively
formulate strategies which are directed towards sustainable development and ethical performance
of the business. Corporate Governance principles if effectively followed by the business can help
businesses to gain a positive image in the society and also improve the market valuation of the
business.

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Reference
Armstrong, C.S., Blouin, J.L., Jagolinzer, A.D. and Larcker, D.F., 2015. Corporate governance,
incentives, and tax avoidance. Journal of Accounting and Economics, 60(1), pp.1-17.
Axelson, U., Jenkinson, T., Strömberg, P. and Weisbach, M.S., 2013. Borrow cheap, buy high?
The determinants of leverage and pricing in buyouts. The Journal of Finance, 68(6), pp.2223-
2267.
Bushee, B.J., Carter, M.E. and Gerakos, J., 2013. Institutional investor preferences for corporate
governance mechanisms. Journal of Management Accounting Research, 26(2), pp.123-149.
Kijewska, A., 2016. Determinants of the return on equity ratio (ROE) on the example of
companies from metallurgy and mining sector in Poland. Metalurgija, 55(2), pp.285-288.
McCahery, J.A., Sautner, Z. and Starks, L.T., 2016. Behind the scenes: The corporate
governance preferences of institutional investors. The Journal of Finance, 71(6), pp.2905-2932.
Obradovich, J. and Gill, A., 2013. The impact of corporate governance and financial leverage on
the value of American firms.
Rehman, S.S.F.U., 2013. Relationship between financial leverage and financial performance:
Empirical evidence of listed sugar companies of Pakistan. Global Journal of Management and
Business Research.

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Tricker, R.B. and Tricker, R.I., 2015. Corporate governance: Principles, policies, and practices.
Oxford University Press, USA.