Page 38 - FINAL CFA I SLIDES JUNE 2019 DAY 10
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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 total 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 operating costs are fixed to variable (cost of sales) –if
ratio is big, there is a 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)
tanties
Business risk – sales risk + operating risk!
• Sales risk = uncertainty about the firm’s sales.
• Operating risk = additional uncertainty about operating earnings caused by fixed operating
costs.
Business risk therefore is 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
(seen on income statement).
Financial risk = additional risk to common stockholders holders when a firm uses fixed cost (debt)
financing (seen on the balance sheet)
