What is the operating leverage phenomenon and what causes it? What is the financ
ID: 2741682 • Letter: W
Question
What is the operating leverage phenomenon and what causes it? What is the financial leverage phenomenon and what causes it? How are these related to business risk and financial risk? What is the operating leverage phenomenon and what causes it? What is the financial leverage phenomenon and what causes it? How are these related to business risk and financial risk? What is the operating leverage phenomenon and what causes it? What is the financial leverage phenomenon and what causes it? How are these related to business risk and financial risk?Explanation / Answer
Answer:
Operating Leverage:
There are two type of costs in total cost under marginal costing. First is variable costs and second is fixed costs. Operating leverage depends upon the structure of variable and fixed costs used in total cost. A firm that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Basically, using fixed costs in total cost causes operating leverage phenomenon.
Formula of Operating Leverage = Contribution margin/ Operating income
Financial Leverage:
Financial leverage refers to using of debt or fixed interest bearing capital in total capital structure. The more debt/fixed interest bearing capital a firm uses, higher will be the financial leverage. Higher degree of financial leverage will lead to higher interest payment, which is risky for any firm. Using of debt/fixed interest bearing capital causes financial leverage phenomenon. Financial leverage can be calculated as below-
Degree of Financial leverage = Earnings per share / Earnings before interest and taxes
Operating leverage in related to business risk (risk that firm will have lower profits) as we saw in above paragraph that using more fixed costs in total cost causes operating leverage and Financial leverage is related to financial risk(risk to pay lower return on capital and risk not to pay principle amount of capital) as it causes due to using of debt/fixed interest bearing capital.
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