Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 93

Comparison of operating leverage and financial leverage The concept of financial leverage was introduced in Chapter 7 and expanded on in Chapter 11. In Exercise 7.15 you were asked to describe the risks associated with financial leverage. You should now review the solution provided for this problem at www.mhhe.com/ marshall9e.

Required:

a.Describe the risks associated with operating leverage.

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b. Outline the similarities and differences between operating leverage and financial leverage. (Hint: Compare Exhibit 12-9 to the discussion and analysis in Exhibits 7-2 and 11-3.)

Step 1 of 3

a)

Finding the risks associated with operating leverage:

• Operating leverage is the ratio of fixed and variable cost which a company uses in determining the amount of operating leverage it has employed. A company, which has a greater fixed cost in relation to variable cost, is said to be highly leveraged.

• A company, which has less sales but high margins, is considered to be highly leveraged. On the other hand, if a company has large volume of sales but lower margins then it is considered to be less leveraged.

• Even though leveraging is employed by a firm to generate higher revenues on its assets, still it could result in huge losses. A higher operating leverage can pose a huge risk for a firm if its future sales forecasts are wrong. If firm could not achieve its forecasted sales figure then this would result in huge deviation from budgeted cash flow.

• Operating leverage could also become risky if the company operates with high fixed cost. In this case if a company could not achieve break-even point then this would result in losses. This risk is often referred to as “business risk”.