BUSINESS RISK: <\/strong>Business risk is also known as operating risk. It implies uncertainty in profits or danger of loss leading to shut down of that business. These risks may arise due to future uncertainties. Example:<\/p>\n\n\n\n FINANCIAL RISK: <\/strong>this risk is associated with the capital structure of the company. A company with no debt financing has no financial risk. The extent of financial risk depends upon the leverage of firm\u2019s capital structure.<\/p>\n\n\n\n CONCLUSION<\/strong><\/p>\n\n\n\n Risk and return are closely inter-related. If there is no risk, there is no return. Business risk is comparatively bigger term than financial risks as financial risk is a part of business risk. Financial risk can be ignored but business risk cannot be avoided.<\/p>\n\n\n\n\n\n\n\n ANSWER:<\/strong><\/p>\n\n\n\n LEVERAGE: <\/strong>Leverage refers to debt or to the borrowings of funds to finance the purchase of the company\u2019s asset. It is used to measure the effect of increase or decrease of fixed cost on the earnings.<\/p>\n\n\n\n Leverage may be<\/p>\n\n\n\n ACCORDING TO THE JAMES HORNE: <\/strong>\u201cLeverage can be defined as the employment of an asset or funds for which the firm pays a fixed cost or fixed return.\u201d<\/p>\n\n\n\n The following are the types of leverages:<\/p>\n\n\n\n Financial leverage may be expressed when the residual net income (earnings after interest and taxes and preference dividend) varies not in proportion with operating profit. This leverage reveals the changes in the taxable income in comparison with the changes in the operations.<\/p>\n\n\n\n In other words, a major part is played by the interest on debt financing, interest on debentures, preference dividend in the entire capital structure of the firm.<\/p>\n\n\n\n The firm may be called as high levered if it has more use of debt and less levered if it has less use of the debt.<\/p>\n\n\n\n Types of financial leverage: <\/strong>The financial leverage are of two types:<\/p>\n\n\n\n Favourable financial leverage: <\/strong>When the EPS (earning per share) increases as an impact of debt financing in the corporate structure, it is called favourable leverage.<\/p>\n\n\n\n Unfavourable financial leverage: <\/strong>When the EPS (earnings per share) decreases as an impact of debt financing in the corporate capital structure, it is called unfavourable financial leverage.<\/p>\n\n\n\n DEGREE OF FINANCIAL LEVERAGE: <\/strong>The degree of financial leverage is the percentage change in taxable profit as a result of percentage change in the operating profit i.e. the ability of the firm to utilize financial charges in order to magnify the effect of changes in EBIT on EPS of the firm.<\/p>\n\n\n\n EPS= Earnings per share<\/p>\n\n\n\n EBIT= Earnings before interest and tax<\/p>\n\n\n\n DFL= Degree of financial leverage<\/p>\n\n\n\n Example: <\/strong>10,000 equity shares @ \u20b910 each= \u20b91,00,000<\/p>\n\n\n\n 10%; 500 debentures of \u20b9100 crores= \u20b950,000<\/p>\n\n\n\n EBIT= 40,000; Find DFL<\/p>\n\n\n\n Answer: <\/strong>DFL= EBIT\/ EBIT-I<\/p>\n\n\n\n = 40,000\/ 40,000-5,000<\/p>\n\n\n\n = 40,000\/ 35,000<\/p>\n\n\n\n = 1.14<\/p>\n\n\n\n Interest= 50,000*10%<\/p>\n\n\n\n TRADING ON EQUITY: <\/strong>Sometimes \u2018financial leverage\u2019 is called \u2018Trading on equity\u2019. This is a device by which the equity shareholders enjoy large amount of profit at the cost of other fixed interest-bearing securities.<\/p>\n\n\n\n The rate of dividend of the equity shares can substantially be increased by the issue of more debentures and preference shares with the fixed rate of interest and the dividend.<\/p>\n\n\n\n Example: <\/strong>Suppose, the total requirement of the capital of the company is \u20b920,00,000 and the expected rate of return on the capital is 12%. If the entire capital consists of the equity shares only, there will be no Trading on equity, but will simply be a return @12% on \u20b920,00,000 by way of the dividends.<\/p>\n\n\n\n Now, suppose the capital structure of the company is:<\/p>\n\n\n\n 10% debentures= \u20b98,00,000<\/p>\n\n\n\n 85 Preference shares= \u20b94,00,000<\/p>\n\n\n\n Rate of return= 12%<\/p>\n\n\n\n Profit= 20,00,000*12%= \u20b92,40,000<\/p>\n\n\n\n Balance available for equity dividend= \u20b91,28,000<\/p>\n\n\n\n Percentage of return on equity capital= (1,28,000\/ 8,00,000) *100= 16%<\/p>\n\n\n\n So by the issue of the debentures and preference shares, trading on equity is possible and as a result the rate of equity dividend increased from 12% to 16%.<\/p>\n\n\n\n EFFECT OF FINANCIAL LEVERAGE ON EPS<\/strong><\/p>\n\n\n\n EFFECT OF FINANCIAL LEVERAGE ON FINANCIAL RISK<\/strong><\/p>\n\n\n\n Operating leverage is the firm\u2019s ability to use the fixed operating cost to magnify the effect of changes in sales on its earnings before interest and taxes.<\/p>\n\n\n\n When the change in the operating profit after charging fixed cost is greater than the percentage change in the sales, the occurrence is called the operating leverage.<\/p>\n\n\n\n Operating leverage arises due to presence of operating costs which can be categorised into three parts:<\/p>\n\n\n\n Fixed costs: <\/strong>It refers to the costs which do not change with the change in the production.<\/p>\n\n\n\n Variable costs: <\/strong>It refers to the cost which changes due to the change in the level of the production. The amount of expenditure increases with the increase in the level of the output and it decreases with the decrease in the level of output.<\/p>\n\n\n\n Semi-variable costs: <\/strong>These are the costs that are partly fixed and partly variable. These costs remain fixed up to a certain level and then starts increasing with the change in the level of the output.<\/p>\n\n\n\n Operating leverage is associated with the business risk.<\/p>\n\n\n\n Business or operating risk is the degree of the uncertainty that the firm has faced in meeting its fixed operating cost where there is variability of EBIT.<\/p>\n\n\n\n CALCULATION OF OPERATING LEVERAGE<\/strong><\/p>\n\n\n\n Example: <\/strong>Let Selling price per unit = \u20b930<\/p>\n\n\n\n Production and sales= 600 units.<\/p>\n\n\n\n Variable cost= \u20b918 per unit<\/p>\n\n\n\n Fixed cost= \u20b91,200<\/p>\n\n\n\n The operating leverage will be calculated as follows:<\/p>\n\n\n\n OPERATING LEVERAGE= Contribution\/ Operating profit = 7,200\/6,000= 1.2<\/strong><\/p>\n\n\n\n DEGREE OF OPERATING LEVERAGE: <\/strong>The degree of operating leverage may be defined as the percentage change in profits resulting from percentage change in sales.<\/p>\n\n\n\n DOL= Percentage change in EBIT\/ Percentage Change in Sales<\/strong><\/p>\n\n\n\n The degree of operating leverage must be greater than 1.<\/p>\n\n\n\n Ideal DOL= (Percentage change in EBIT\/Percentage change in sales)>1<\/strong><\/p>\n\n\n\n Example: <\/strong>A firm at present has a sales of 500 units @ \u20b910 per unit. Its variable cost is \u20b97 per unit and fixed expenses are \u20b9800 per annum. The firm\u2019s expected sales for next year will be 700 units. Compute degree of operating leverage.<\/p>\n\n\n\n Percentage Increase in EBIT= (Increase in EBIT\/ Original EBIT)*100<\/p>\n\n\n\n =(600\/700)*100<\/p>\n\n\n\n =85.71%<\/p>\n\n\n\n **** Increase in EBIT= 1300-700= 600<\/p>\n\n\n\n Percentage Increase in Sales= (Increase in sales\/ Original sales)*100<\/p>\n\n\n\n =(2,000\/5,000)*100<\/p>\n\n\n\n =40%<\/p>\n\n\n\n ****Increase in sales= 7,000-5,000= 2,000<\/p>\n\n\n\n Degree of operating leverage= (Percentage change in EBIT\/ Percentage change in Sales)<\/strong><\/p>\n\n\n\n = 85.71\/40<\/p>\n\n\n\n =2.14<\/p>\n\n\n\n IMPORTANCE OF OPERATING LEVERAGE<\/strong><\/p>\n\n\n\n Operating leverage shows the operating risk and is measured by the percentage change in EBIT due to percentage change in sales.<\/p>\n\n\n\n The financial leverage shows the financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Both operating and financial leverages are closely concerned with ascertaining the firm\u2019s ability to cover fixed costs and the combination of both is known as combined or total leverage.<\/p>\n\n\n\n The risk is associated with total leverage is known as total risk.<\/p>\n\n\n\n Combined Leverage= Operating Leverage* Financial Leverage<\/strong><\/p>\n\n\n\n Combined Leverage= (C\/ EBIT)*(EBIT\/EBT)<\/strong><\/p>\n\n\n\n Combined Leverage= C\/ EBT or (Sales\/Variable cost)\/ (Sales- Variable cost- Fixed cost)<\/strong><\/p>\n\n\n\n DEGREE OF COMBINED LEVERAGE<\/strong><\/p>\n\n\n\n The degree of combined leverage measures the effect of a percentage change in sales on percentage change in EPS.<\/p>\n\n\n\n DCL= DOL*DFL<\/strong><\/p>\n\n\n\n DCL= (Percentage change in EBIT\/ Percentage change in sales)* (Percentage in EPS\/ Percentage change in EBIT)<\/strong><\/p>\n\n\n\n DCL= Percentage changer in EPS\/ Percentage change in sales<\/strong><\/p>\n\n\n\n Combined leverage may be:<\/p>\n\n\n\n IMPORTANCE OF COMBINED LEVERAGES<\/strong><\/p>\n\n\n\n Answer:<\/strong><\/p>\n\n\n\n MEASUREMENT OF OPERATING RISK: <\/strong>Operating risk refers to the risk of the firm not being able to cover its fixed operating costs. Since, operating leverage depends on operating costs, larger fixed operating costs indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is good when sales are rising but bad when they are falling.<\/p>\n\n\n\n MEASUREMENT OF FINANCIAL RISK: <\/strong>It refers to the risk of the firm not being able to cover its fixed financial costs. Since financial leverage depends on fixed financial costs indicates higher degree of financial leverage and thus high financial risk. High financial leverage is good when operating profit is rising and when it is falling.<\/p>\n\n\n\n MANAGING RISK: <\/strong>Relationship between operating leverage and financial leverage is multiplicative rather than additive. Operating leverage and Financial leverage can be combined in a number of different ways to obtain a desirable degree of total leverage and level of total firm risk.<\/p>\n\n\n\n DESIGINING APPROPROATE CAPITAL STRUCTURE MIX: <\/strong>To design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earnings per share. One widely used mean of examining the effect of leverage to analyse the relationship between EBIT and earnings per share.<\/p>\n\n\n\n INCREASE PROFITABILITY: <\/strong>Leverage is an effort or attempt by which a firm tries to show high result or more benefit by using fixed costs assets and fixed return sources of capital. It ensures maximum utilization of capital and fixed assets in order to increase the profitability of a firm. It helps to know the reasons not having more profits by a company.<\/p>\n\n\n\n\n\n\n\n QUESTION: Difference between Operating leverage and financial leverage?<\/strong><\/p>\n\n\n\n Answer:<\/strong><\/p>\n\n\n\n\n
DIFFERENCE BETWEEN FINANCIAL RISK AND BUSINESS RISK<\/h4>\n\n\n\n
BASIS OF DIFFERENCE<\/strong><\/td> BUSINESS RISK<\/strong><\/td> FINANCIAL RISK<\/strong><\/td><\/tr> Meaning<\/strong><\/td> The risk of insufficient profit to meet out the expenses is known as business risk.<\/td> Financial risk is the risk arising due to the use of debt in the financial structure of the company.<\/td><\/tr> Evaluation<\/strong><\/td> Business risk is evaluated by the variability in the Earnings before Interest and Tax (EBIT).<\/td> Financial risk is evaluated by leverage multiplier and debt to asset ratio.<\/td><\/tr> Connected with<\/strong><\/td> Business risk is connected with the economic environment.<\/td> Financial risk is connected with the use of the debt.<\/td><\/tr> Minimization or Prevention<\/strong><\/td> Business risk cannot be minimized.<\/td> If the firm does not use debt funds, there will be no risk.<\/td><\/tr> Types<\/strong><\/td> Compliance riskOperation riskReputation riskStrategic risk<\/td> Credit RiskMarket riskLiquidity riskExchange rate risk etc.<\/td><\/tr> Disclosed by<\/strong><\/td> Business risk is disclosed by difference in not operating income and net cash flows.<\/td> Financial risk is disclosed by difference in return of equity shareholders.<\/td><\/tr> Measured by<\/strong><\/td> Business risk is measured by operating leverage.<\/td> Financial risk is measured by financial leverage.<\/td><\/tr><\/tbody><\/table> QUESTION: What do you mean by Leverages? What are the different kinds of leverages?<\/strong><\/h3>\n\n\n\n
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TYPES OF LEVERAGE<\/strong><\/h4>\n\n\n\n
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FINANCIAL LEVERAGE OR TRADING ON EQUITY<\/strong><\/h4>\n\n\n\n
![\"\"](\"https:\/\/commerceiets.com\/wp-content\/uploads\/2022\/11\/image-2.png\")
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Profit<\/td> 2,40,000<\/td><\/tr> Less: Debentures Interest<\/td> (80,000)<\/td><\/tr> Less: Preference dividend<\/td> (32,000)<\/td><\/tr> <\/td> 1,28,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n \n
<\/td> High degree of financial leverage<\/strong><\/td> Low degree of financial leverage<\/strong><\/td><\/tr> Variability in shareholder\u2019s earnings<\/strong><\/td> Increases<\/td> Decreases<\/td><\/tr> Probability of insolvency<\/strong><\/td> Decreases<\/td> Increases<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n OPERATING LEVERAGE<\/strong><\/h4>\n\n\n\n
![\"\"](\"https:\/\/commerceiets.com\/wp-content\/uploads\/2022\/11\/image-4-1.png\")
![\"\"](\"https:\/\/commerceiets.com\/wp-content\/uploads\/2022\/11\/image-5-1.png\")
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Total sales (600@30)<\/td> 18,000<\/td><\/tr> Less: Variable cost (600*18)<\/td> (10,800)<\/td><\/tr> Contribution<\/td> 7,200<\/td><\/tr> Less: fixed cost<\/td> (1,200)<\/td><\/tr> Operating Profit or EBIT<\/td> 6,000<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n <\/td> Present sales<\/strong> (500 units)<\/strong><\/td> Expected sales<\/strong> (700 units)<\/strong><\/td><\/tr> Sales @ 10 per unit<\/td> 5,000<\/td> 7,000<\/td><\/tr> Less: Variable cost @ 7 per unit<\/td> (3,500)<\/td> (4,900)<\/td><\/tr> Contribution<\/strong><\/td> 1,500<\/strong><\/td> 2,100<\/strong><\/td><\/tr> Less: fixed costs<\/td> (800)<\/td> (800)<\/td><\/tr> Operating Profit<\/strong><\/td> 700<\/strong><\/td> 1,300<\/strong><\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n \n
COMBINED LEVERAGE<\/strong><\/h4>\n\n\n\n
![\"\"](\"https:\/\/commerceiets.com\/wp-content\/uploads\/2022\/11\/image-7-1.png\")
\n
QUESTION: Discuss the significance of leverages?<\/strong><\/h3>\n\n\n\n
DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE<\/h4>\n\n\n\n
Basis of difference<\/strong><\/td> Operating leverage<\/strong><\/td> Financial leverage<\/strong><\/td><\/tr> Meaning<\/strong><\/td> Use of the such assets in the company\u2019s operations for which it has to pay fixed costs is known as operating leverage.<\/td> Use of debt in capital structure of company for which it has to pay interest expenses is known as financial leverage.<\/td><\/tr> Measures<\/strong><\/td> It measures the effect of operating costs.<\/td> It measures the effect of interest expenses.<\/td><\/tr> Relates<\/strong><\/td> It relates the sales and EBIT.<\/td> It relates to the EBIT and EPS.<\/td><\/tr> Preferable<\/strong><\/td> The operating leverage should be low as it ensures that there is low level of operating risk.<\/td> The financial leverage should be high as it shows that the firm will incur profit only when the operating profit or contribution is rising.<\/td><\/tr> Formula<\/strong><\/td> Contribution\/ EBIT<\/td> EBIT\/EPS<\/td><\/tr> Risk<\/strong><\/td> It gives rise to business risk.<\/td> It gives rise to financial risk.<\/td><\/tr> Degree<\/strong><\/td> Percentage change in EBIT\/ Percentage change in sales<\/td> EBIT\/ EBIT-I Or EBIT\/ EBT<\/td><\/tr> Cost\/ Capital structure<\/strong><\/td> It is determined by the cost structure of the firm.<\/td> It is determined by capital structure of the firm.<\/td><\/tr>