6.4 Leverage and Risk; Operating leverage and Operating risk, financial leverage and financial risk and total leverage and total risk.

Leverage and risk are interconnected concepts in financial management, referring to the use of borrowed funds (debt) to finance investments and the potential impact on the company’s risk profile. There are different types of leverage and associated risks, including operating leverage, financial leverage, and total leverage.

1. Operating Leverage and Operating Risk: Operating leverage relates to the use of fixed costs, such as depreciation, rent, and salaries, in a company’s cost structure. It refers to the extent to which fixed costs are used in the production or operation of a business. Companies with high operating leverage have a larger proportion of fixed costs compared to variable costs.Operating risk, on the other hand, represents the risk of a company’s earnings and cash flows being affected by changes in sales or revenue. It is influenced by factors such as the company’s cost structure, market demand, and the degree of competition.

   When a company has high operating leverage, a small change in sales or revenue can lead to a significant impact on profits. This results in higher operating risk because fixed costs remain constant regardless of the level of sales. Conversely, companies with lower operating leverage and more variable costs have lower operating risk since costs can be adjusted based on sales levels.

2. Financial Leverage and Financial Risk: Financial leverage refers to the use of debt to finance a company’s operations or investments. It involves the use of borrowed funds, such as loans or bonds, to increase the potential returns to shareholders. By using debt, a company can amplify its returns on equity if the return on investment exceeds the cost of debt.Financial risk represents the risk associated with the use of debt financing. The higher the level of debt in a company’s capital structure, the higher the financial risk. This is because debt holders have a fixed claim on the company’s assets and earnings, and the company must meet the interest and principal payments regardless of its financial performance.

   When a company has high financial leverage, even a small decline in operating income can significantly affect the profitability and solvency of the business. It increases the financial risk because the company has higher interest expenses and debt obligations to fulfill.

3. Total Leverage and Total Risk: Total leverage combines both operating leverage and financial leverage to assess the overall risk profile of a company. It measures the sensitivity of a company’s earnings per share (EPS) to changes in sales or revenue.Total risk represents the overall risk faced by a company, considering both operating risk and financial risk. It considers the impact of changes in sales on both the operating income and the interest expense related to debt financing.

   Companies with higher total leverage have a greater exposure to changes in sales, as both fixed costs (operating leverage) and fixed interest expenses (financial leverage) contribute to the overall risk. Conversely, companies with lower total leverage have a lower sensitivity to changes in sales.

Managing leverage and risk is crucial for companies. While leverage can enhance returns, it also increases the potential downside if business conditions deteriorate. Striking a balance between different types of leverage and risk is essential for maintaining financial stability and maximizing shareholder value.