This paper addresses the solutions to Case Study 12.31 and 12.32 in the textbook authored by David Marshall, Wayne McManus, and Daniel Viele “Accounting; What the numbers mean.” Both case studies bring about a better understanding of operating and financial leverage. This discussion includes the return on investment, return on equity, contribution margin, and break-even point. All these terms associate with the two types of leverage.
The exertion of a force that creates an advantage describes the action of leverage. In engineering, this force creates a mechanical advantage like the action of a pry bar. In the world of accounting, leverage describes the use of borrowed capital that is expected to bring in a greater profit (advantage ) over the interest payable. This description of leverage applies to both financial and operating leverage.
So what is financial leverage? Marshall defines financial leverage as “the use of debt (with a fixed interest rate) that causes a difference between the return on investment and the return on equity”. (Marshall, McManus, & Viele, 2014). Both the return on investment in the return on equity play an important role in determining a company’s profitability as well as the calculation for financial leverage. The return on investment represents as a relationship between that net income and the total average of the assets where the net income is divided by the average assets and then converted to a percentage. In some cases the operating income is used in place of the net income to express the return on investment. This variation to the return on investment equation gives a better look at how well the company utilizes its assets. The return on investment reflects management’s abilities to use assets in order to produce a profit. As a rule of thumb, the ROI for most American