Question 1 (b)
Operating risk and financial risk, and their measurement by leverage
9 marks
- Time to write
- About 18 minutes
Question
Question 1 (b) · 9 marksDifferentiate between the Operating risk and the Financial risk of a firm. How are these risks measured by leverage analysis?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Differentiate…How…?Two asks in one question: answer both.
- Differentiate betweenSet the differences out in a table, basis by basis, not as two separate essays.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Operating risk explained 2 marks 4 min
- 2 Financial risk explained 2 marks 4 min
- 3 Differences 2 marks 3 min
- 4 Measurement by DOL, DFL and DCL 3 marks 5 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1–4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Operating (business) risk is the variability of operating profit (EBIT) caused by changes in sales. It arises from the firm's fixed operating costs: the higher they are, the more EBIT swings for a given change in sales. It depends on the nature of the business and its cost structure.
1The baker signs for the bank's money at a fixed interest.
Financial leverageThe use of fixed-charge funds (debt, preference shares) in the capital structure.
2The ovens run full, the queue is long—the loan earns more than it costs, and the owner's share swells.
FavourableThe fixed-charge funds earn more than they cost, so EPS rises.
3The same counter empty: the interest envelope still goes out, from a thinner cash box.
UnfavourableWhen ROI is below the cost of debt: EPS falls.
Financial risk is the additional variability of the shareholders' earnings (EPS) caused by the use of fixed-charge finance, i.e. debt and preference shares. Interest must be paid whatever the EBIT, and the preference dividend, though not a legal obligation, is a fixed charge that ranks before the equity shareholders. So the more such finance, the more EPS swings, and the greater the risk of being unable to meet the charges.
| Basis | Operating risk | Financial risk |
|---|---|---|
| Source | Fixed operating costs | Interest and preference dividend |
| Effect | Sales changes magnified in EBIT | EBIT changes magnified in EPS |
| Decision it reflects | Investment and cost structure | Financing (capital structure) |
| Avoidable? | Inherent in the business | Avoidable by not using fixed-charge finance (debt or preference shares) |
Measurement by leverage analysis
- Operating risk → degree of operating leverage (DOL) = % change in EBIT ÷ % change in sales, or contribution ÷ EBIT. With a DOL of 3, an 8% fall in output cuts EBIT by 24%.
- Financial risk → degree of financial leverage (DFL) = % change in EPS ÷ % change in EBIT, or EBIT ÷ EBT (with no preference shares). With a DFL of 2, a 5% fall in EBIT cuts EPS by 10%.
- Total risk → degree of combined leverage (DCL) = DOL × DFL = % change in EPS ÷ % change in sales.
Each degree is undefined at the corresponding break-even point and very high near it, which signals high risk.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Operating risk explained | 2 |
| 2 | Financial risk explained | 2 |
| 3 | Differences | 2 |
| 4 | Measurement by DOL, DFL and DCL | 3 |
| Total | 9 |
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