Question

What does risk taking have to do with the use of operating and financial leverage?

Short answer

A company that operates with both high operating and financial leverage can be risky investment. High operating leverage means company sell small quantity with high margin. It may lead to the significant risk when the company wrongly forecast the future sales.

High financial leverage occurs when a company raises debt from the market which may lead to the increase in interest cost of the company and also decrease in the company’s profitability during the year.

Step-by-step solution

Step-by-Step Solution:Step 1: Operating leverage

Operating leverage is computed to measure the percentage or degree at which a company can increase the operating income by increasing the operating revenues. High operating levereag is risky when the margin or percentage is high. It is so because if the company wrongly forecast the future, then there is a large difference between the actual cash flow and the budgeted cash flows.

Financial leverage

Financial leverage is computed by an organization to know the use of the debts to buy more assets. If the financial leverage is high, then it is risky because it denotes that the company use more debts to acquire the assets. And, when the company use more debt, the interest expense increases and leads to the less income of the company.