X Limited and Y Limited are two mid-sized companies operating in the same competitive industry. Both companies have recently undergone a financial…

CA Intermediate · Financial Management and Strategic Management · RTP · September 2025
X Limited and Y Limited are two mid-sized companies operating in the same competitive industry. Both companies have recently undergone a financial performance review to assess their operational efficiency, cost structure, and overall financial risk. You, as a financial analyst, have been provided with selective financial indicators and are required to draw insights and comparisons based on leverage analysis and income statement reconstruction. The management of X Limited has disclosed that the company is currently operating with a Margin of Safety (M/S) ratio of 0.1667. In contrast, Y Limited has a Margin of Safety that is twice as high as that of X Limited. Both companies maintain a Financial Leverage of 3. Their variable cost ratios are 60% for X Limited and 50% for Y Limited. In terms of financing costs, X Limited incurs an annual interest expense of 30,000. Y Limited, however, incurs an interest cost that is 300% higher than X Limited. Both companies are subject to a corporate tax rate of 30%, which affects their net profitability after interest and taxes. You are required to PREPARE Income statement for both the companies and IDENTIFY the company which is better placed with reasons based on leverages.

Suggested Answer and Working Notes:

Company X (i) Financial Leverage = EBIT / EBT i.e EBIT - Interest So, 3 = EBIT / (EBIT - 30,000) Or, 3 (EBIT – 30,000) = EBIT Or, 3 EBIT – 90,000 = EBIT Or, 2 EBIT = 90,000 Or, EBIT = 45,000 (ii) Margin of safety = 0.1667 Operating Leverage = 1/Margin of safety = 1/0.1667 = 6 Or, 6 = Contribution / EBIT Or, 6 = Contribution / 45,000 Or, Contribution = 2,70,000 Sales = Contribution / P/V Ratio(1- variable cost ratio) P/V Ratio = 1 - Variable Cost Ratio = 1 - 0.60 = 0.40 or 40% Sales = 2,70,000 / 40% = 6,75,000 (iii) Fixed Cost = Contribution – EBIT = 2,70,000 – 45,000 = 2,25,000 Company Y (i) Financial Leverage = EBIT / EBT i.e EBIT - Interest Interest for Y Ltd = 30,000 + (₹ 30,000 × 300%) = 30,000 +90,000 = 1,20,000 So, 3 = EBIT / (EBIT - 1,20,000) Or, 3 (EBIT - 1,20,000) = EBIT Or, 3 EBIT - 3,60,000 = EBIT Or, 2 EBIT = 3,60,000 Or, EBIT = 1,80,000 (ii) Margin of safety = 0.1667 x 2 = 0.3333 Operating Leverage = 1/Margin of safety = 1/0.3333 = 3 Or, 3 = Contribution / EBIT Or, 3 = Contribution /1,80,000 Or, Contribution = 5,40,000 Sales = Contribution / P/V Ratio(1- variable cost ratio) P/V Ratio = 1 - Variable Cost Ratio = 1 - 0.50 = 0.50 or 50% Sales = 5,40,000 / 50% = 10,80,000 (iii) Fixed Cost = Contribution – EBIT = 5,40,000 - 1,80,000 = 3,60,000 Income Statements of X Ltd and Y Ltd X Ltd (₹) Y Ltd (₹) Sales 6,75,000 10,80,000 Less: Variable cost 4,05,000 5,40,000 Contribution 2,70,000 5,40,000 Less: Fixed Cost 2,25,000 3,60,000 Earnings before interest and tax (EBIT) 45,000 1,80,000 Less: Interest 30,000 1,20,000 Earnings before tax (EBT) 15,000 60,000 Less: Tax @ 30% 4,500 18,000 Earnings after tax (EAT) 10,500 42,000 Comment based on Leverage Comment based on leverage – Company Y is better than company X of the following reasons: (i) Capacity of Company Y to meet interest liability is same that of companies X (from EBIT/Interest ratio) [X = 45,000 /30,000 = 1.5, Y = 1,80,000 /1,20,000 = 1.5] (ii) However, Company Y has lesser financial risk as the total risk (business and financial) of company Y is lower (combined leverage of Company X is 18 and Company Y is 9).

Topics: Part-A: Financial Management

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