1. Reorder Level, Minimum Level, Maximum Level, Average Stock Level 2.

1. Name – Chandresh Madhyan Subject – Corporate Finance
Reorder Level, Minimum Level, Maximum Level, Average Stock Level
Once the Economic Order Quantity (EOQ) is determined, then next thing to
decide is what level of order needs to be placed.
If the inventory level is high, it will unnecessary block the capital and if
the inventory level is low, it will disturb the production with stock out
situation. So to maintain optimum inventory level with minimum costs, below
parameters need to be determined.
Re-order level
It is defined as level of inventory (stock) for which an order should be
placed for replenishing the current stock of inventory on time.
Generally, the re-order level lies between minimum stock level and Maximum
stock level.
Re-order Level = Maximum Usage X Maximum Delivery Time
Minimum Level
It is defined as level of inventory (stock) that must be always
maintained to avoid disruption in production. If the inventory is less
than minimum level, production will come to a stop. The factors considered
while determining minimum stock level are lead time, consumption rate,
material nature etc.
Minimum Level = Re-order Level – (Normal Usage X Average
Delivery Time)
Maximum Level
It is defined as level of inventory (stock) beyond which a firm should
not maintain the inventory. If the firm stocks the inventory beyond the
maximum stock level it is called Over stocking. Excessive inventory
involves heavy cost of inventory because it blocks the firm funds in
inventory, excess carrying cost, wastage, obsolescence and theft cost.
Therefore firms should not stock above the maximum stock level.
Maximum Level = Re-order Level + re-order quantity – (minimum
usage x minimum delivery time)
Average Stock level
It is defined as median value of an inventory maintained by the firm. It
ensures the smooth running of the production cycle with minimal
costs. Average Stock Level = Minimum level + (re-order quantity/2)

2. Operating Leverage, Financial Leverage & Combined Leverage
Operating Leverage
It is present any time as a firm has operating costs regardless of the level of
production. These are to be paid regardless of the amount of revenue of the
firm.
Therefore, operating leverage is defined as the firm’s ability to use
operating costs to magnify the effect of changes in sales on its
earnings before interest and taxes (EBIT).
The degree of operating leverage is defined as the change in the
percentage of operating income (EBIT), for the change in percentage
of sales revenue. Operating leverage may be favorable or unfavorable.
Degree of Operating Leverage = % change in EBIT
% change in Sales
Financial Leverage
A firm needs long-term funds for long-term activities like diversification,
expansion and modernization etc. These funds required can be raised by
2 sources – equity & debt.
The use of fixed charges, sources of funds such as debt & preference
share capital along with the equity share capital in capital structure
is described as financial leverage.
It is defined as the ability of the firm to use fixed financial charges to
magnify the effects of changes in EBIT on the firm’s earnings per
share (EPS). Financial leverage can be positive or negative.
Degree of Financial Leverage = % change in EPS
% change in EBIT
Combined Leverage
The operating leverage effects operating risk and is measured by the
percentage change in EBIT due to the percentage change in Sales. The
financial leverage effects financial risk and is measured by the percentage
change in EPS due to the percentage change in EBIT.
Both these leverages are closely related with ascertainment of the firm’s
ability to cover fixed charges (fixed operating costs in case of
operating leverage and fixed financial costs in case of financial
leverage), the sum of both gives the combined leverage.

3. The degree of combined leverage can be defined as the percentage
change in EPS due to the percentage change in Sales.
Combined Leverage = % change in EBIT X % change in EPS
% change in Sales % change in EBIT
= % change in EPS
% change in Sales
= Contribution
EBT
Working of the problem
Working of Leverages
Sales Revenue 4,00,000 X 5 2000000.00
Less: Variable Cost 4,00,000 X 0.6 240000.00
Contribution 1760000.00
Less: Fixed Cost 200000.00
EBIT 1560000.00
Less: Interest (3,500) 3500.00
Earnings Before Tax (EBT) 1556500.00
Operating Leverage = Contribution/EBIT 1.128205128
Financial Leverage = EBIT/EBT 1.002248635
Combined Leverage = Contribution/EBT 1.130742049
1. The Operating leverage value of 1.128 clearly shows that the firm is not
able to modify the operating costs incurred to magnify the sales
on its earning before interest and tax.
It doesn’t take much risk as high degree of operating leverage indicates
high degree of risk. For the firm, high operating leverage will be good
when revenues keep rising and bad when they are falling.
2. The Financial leverage value of 1.002 clearly shows that the firm
doesn’t earn on the funds raised for long term activities. It is just
able to use the funds without adding much value to the firm or its
activities. Financial leverage can be favorable, when the firm earns
more on the assets purchased with the funds than the fixed cost of
their use and vice versa.
On other hand, high financial leverage leads to high financial risk. In this
case, the firm doesn’t take risk so financial risk is not high.

4. 3. The combined leverage value of 1.130 shows the effect on firm from
Operating leverage and Financial leverage. Both leverages are
closely related with the ascertainment of the firm’s ability to cover fixed
charges.
In this case, operating leverage being slightly more than financial
leverage, states that operating leverage is better in firm than
financial leverage. Firm should further try to increase their degree of
operating leverage.
The combined leverage can work in both directions. It is favorable
when sales of the firm increase and unfavorable when sales of the
firm decrease. The change in sales results in more than proportion
returns in the form of EPS. They have tremendous acceleration or
deceleration effects on EBIT & EPS because of which it is very necessary
for the firm to have right combination of both leverages. A proper
combination will be blessing for the firm growth while improper
combination will be curse for the firm.
Hence, it is very necessary for the firm to convert its operating & fixed
funds to sales which will help increase Operating & Financial
leverage. Further, firm should have right combination of Operating &
Financial leverage i.e. combined leverage to increase its EBIT and EPS.