115 CFA
File: Corporate Finance - Reading 34 - 1. Business Risk and Operating Leverage

1. Business Risk and Operating Leverage

a. define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk;

b. calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage;

c. analyze the effect of financial leverage on a company's net income and return on equity;

What is the definition of leverage?
Leverage is the extent to which fixed costs are used in a company's cost structure.

What is operating leverage?
Operating leverage is the extent to which fixed operating costs (e.g., depreciation, rent) are used in a firm's operations.

What is financial leverage?
Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.

What is business risk?
Business risk is the uncertainty (variability) about projections of future operating earnings. It is the single most important determinant of capital structure. If other elements are the same, the lower a firm's business risk, the higher its optimal debt ratio.

What is sales risk?
The sales risk is the uncertainty regarding the price and quantity of the firm's goods and services. If the demand for and the price of a firm's goods and services are stable, its sales risk is considered low.

What is operating risk?
The operating risk is the uncertainty caused by a firm's operating cost structure. If a high percentage of operating costs are fixed costs, operating risk is considered to be high.

What is the degree of operating leverage (DOL)?
The degree of operating leverage (DOL) is defined as the percentage change in EBIT (operating income) that results from a given percentage change in sales. It measures the impact of a change in sales on EBIT.

What is per unit contribution margin?
Per unit contribution margin is the amount that each "unit" contributes to covering fixed costs

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