Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail: With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.) What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?
Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail: With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.) What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?
Chapter1: Financial Statements And Business Decisions
Section: Chapter Questions
Problem 1Q
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Question
Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail:
- With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.)
- What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?
Expert Solution
Concept
The operating leverage represent the operating risk capacity of the business.
It is calculated by dividing Contribution with the Earnings before interest and tax or Operating profits, where
Contribution is the difference between the Sales and the variable cost.
Earnings before interest and tax or Operating profits is the difference between the contribution and the Fixed cost.
Contribution is the result of variable factors whereas the Fixed cost remains constant throughout the period.
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