Leverage

Answer

Business risk is concerned with the sensitivity of EBIT, it is the risk of being unable to cover operating costs. We have seen that as a firm's fixed operating costs increase, the volume of sales necessary to cover all operating costs increases. The operating break even point is a good measure of the firms business risk. The higher the break even point, the greater the degree of business risk that is present

Sources of business risk

  1. variability of demand
  2. variability of price
  3. variability of cost of production
  4. operating leverage
  5. cost of sales

 

Financial risk is the risk of being unable to cover financial costs. As financial charges increase, the level of EBIT necessary to cover these charges also increases Increasing financial leverage results in increasing risk, since increased financial payments require the firm to maintain a higher level of EBIT in order to stay in business. If the firm cannot cover these financial payments, it can be forced out of business by creditors whose claims are unsettled.

Sources of financial risk

  1. Interest of debt
  2. Devident on preferred stock

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