Leverage

Leverage ⇒ refers to the amount of fixed costs a firm has. These fixed costs may be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt. Greater leverage leads to greater variability of the firm’s after-tax operating earnings and net income. A given change in sales will lead to a greater change in operating earnings when the firm employs operating leverage; a given change in operating earnings will lead to a greater change in net income when the firm employs financial leverage.

Business risk ⇒ refers to the 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.

Business risk is the combination of sales risk and operating risk.

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.