Q5-5DQ What does risk taking have to do... [FREE SOLUTION]

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Foundations Of Financial Management

Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen

Business Studies

16th Edition 路 768 pages

ISBN: 9781259277160

Chapter 2: Q5-5DQ (page 143)

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

Short Answer

Expert verified

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鈥檚 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.

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Indicate whether item is on Balance sheet (BS) or Income statement (IS)	If on Balance sheet, designate which category	Item
		Accounts receivable
		Retained earnings
		Income tax expense
		Accrued expense
		Cash
		Selling and administrative expenses
		Plant and equipment
		Operating expenses
		Marketable securities
		Interest expense
		Sales
		Notes payable (6 month)
		Bonds payable, maturity 2019
		Common stock
		Depreciation expense
		Inventories
		Capital in excess of par value
		Net income (earning after tax)
		Income tax payable

Sales to total assets	1.90 times
Total debts to total assets	35%
Current ratio	2.50 times
Inventory turnover	10.00 times
Average collection period	20 days
Fixed assets turnover	5.00 times

Cash		Current debts
Account receivable		Long term debts
Inventory		Total debts
Total current assets		Equity
Fixed assets
Total assets		Total debts and equity

Lenow		Hall
Debt @ 10%	\(100,000	Debt @ 10%	\)200,000
Common stock, \(10 par	200,000	Common stock, \)10 par	100,000
Total	\(300,000	Total	\)300,000
Shares	20,000	Common shares	10,000

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

Short Answer

Step by step solution

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

Financial leverage

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