Question

What is the operating leverage phenomenon and what causes it?

What is the financial leverage phenomenon and what causes it?

How are these related to business risk and financial risk?

Answer 1

The operating leverage effect is the phenomenon whereby a small change in sales triggers a relatively large change in operating income. It is caused by the presence of fixed operating costs. The potential benefits are that if sales are rising operating income will rise more quickly. The negative consequences are that falling sales will cause operating income to fall more quickly, including negative values.

Financial leverage is the quantity of borrowed debts used to acquire additional assets. In simple words, it can be referred to as the total amount of debt in the capital structure. It is evaluated as the correlation between total assets and total liabilities.

I have uploaded an image so that you will be able to understand the concept briefly and precisely.