Page 45 - FINAL CFA SLIDES DECEMBER 2018 DAY 11

Session Unit 11:

37. Measures of Leverage

LOS 37.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and
classify a risk., p.66

Leverage (gearing) -the extent to which a firms totals costs (operating or interest) are fixed: Greater

leverage leads to greater variability of the firm’s after-tax operating earnings and net income:
• Operating leverage –extent to which total costs are fixed (operating costs) to variable (cost of sales)
–as if costs are fixed, there is bigger impact (positive or negative) on net income;

• Financial leverage –debt versus equity (interest is fixed cost, except that it is finance cost as
opposed to operating cost)
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Business risk –the combination of sales risk and operating risk associated with a firm’s operating
income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to
produce those revenues.

• Sales risk is the uncertainty about the firm’s sales.
• Operating risk refers to the additional uncertainty about operating earnings caused by fixed
operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm’s
operating risk.

Financial risk refers to the additional risk that the firm’s common stockholders must bear when a firm
uses fixed cost (debt) financing. When a company finances its operations with debt, it takes on fixed

expenses in the form of interest payments. The greater the proportion of debt in a firm’s capital
structure, the greater the firm’s financial risk.