Leverage, Business Risk, and Financial Risk
A firm is said to be leveraged, if it has fixed costs. Using leverage, a firm can magnify the potential returns to the firm. The fixed costs may be fixed operational costs or fixed financial costs. Examples of fixed operational costs include plant and machinery, and building. An example of fixed financial cost is interest payments associated with debt financing.
Before we learn more about leverage we need to understand the business risk and financial risk faced by the firm.
Business risk is core to the existence of any business and is associated with the operating earnings. It refers to the probability of loss inherent in a firm's operations and environment (such as competition and adverse economic conditions) that may impair its ability to provide returns on investment. From a shareholder perspective, firms are paid to take business risk, and it is inherent in all business decisions, and investments, for example, marketing and promotion, sales strategy, etc.
Business risk is a combination of sales risk and operating risk.
Sales risk refers to the variability in the profits of the firm due to uncertainty of sales price and volume.
Operating risk refers to the uncertainty about operating earnings due to fixed operating costs. If a firm has high fixed operating costs compared to variable costs, then operating risk is high.
Financial risk is the additional risk faced by the shareholders of the firm due to debt financing. The higher the debt as a portion of firm's total capital, the higher is the financial risk.