R37: Measures of Leverage

Which of the following is least likely directly related to changes in the number of units that a company produces and sells? The degree of financial leverage The degree of total leverage The degree of operating leverage

Answer: A The DTL and DOL are different at different levels of units sold. The DFL is different at different levels of operating earnings.

Consider the following statements: Statement 1: Under Chapter 7 bankruptcy, the original business ceases to exist. Statement 2: A company with high financial costs is less likely to undergo successful reorganization than a company with higher operating costs because operating costs can be controlled. Which of the following is most likely? Only Statement 1 is correct. Only Statement 2 is correct. Both statements are correct.

Answer: A Under Chapter 7 bankruptcy (liquidation) the original business ceases to exist. A company with high financial costs is more likely to undergo successful reorganization that a company with higher operating costs because the company can negotiate with creditors and grant them equity in the company in return for their claims on the company.

Consider the following statements: Statement 1: The DOL measures the sensitivity of net income to changes in the number of units sold. Statement 2: The DFL measures the sensitivity of net income to changes in operating income. Which of the following is most likely? Only Statement 1 is correct. Only Statement 2 is correct. Both statements are correct.

Answer: B The DOL measures the sensitivity of operating income to changes in the number of units sold.

Which of the following statements is least likely? Management has more control over a company's degree of financial leverage than its degree of operating leverage. The degree of financial leverage is different at different levels of operating income. All other things remaining the same, a company with a larger ratio of tangible assets to intangible assets will be able to use less financial leverage

Answer: C All other things remaining the same, a company with a larger ratio of tangible assets to intangible assets will be able to use more financial leverage, as it will be able to use its tangible assets to collateralize its borrowings.

At the point where operating income equals zero, which of the following is most likely? DOL is negative. Operating income is not very sensitive to changes in operating income. DOL is undefined.

Answer: C DOL is undefined when operating income equals zero. It is negative when the company makes operating losses and is most sensitive to changes in operating income when operating income equals zero.

The business risk of a particular company is most accurately measured by the company's: debt-to-equity ratio. efficiency in using assets to generate sales. operating leverage and level of uncertainty about demand, output prices, and competition.

C is correct. Business risk reflects operating leverage and factors that affect sales (such as those given).

If two companies have identical unit sales volume and operating risk, they are most likely to also have identical: sales risk. business risk. sensitivity of operating earnings to changes in the number of units produced and sold.

C is correct. The companies' degree of operating leverage should be the same, consistent with C. Sales risk refers to the uncertainty of the number of units produced and sold and the price at which units are sold. Business risk is the joint effect of sales risk and operating risk.

degree of operating leverage (DOL)

DOL is the ratio of the percentage change in operating income to the percentage change in units sold.

degree of financial leverage (DFL)

Financial risk can be measured as the sensitivity of cash flows available to owners to changes in operating income.

Business risk

is the risk associated with operating earnings. Operating earnings are risky because total revenues are risky, as are the costs of producing revenues. Business risk is therefore the combination of sales risk and operating risk.

Operating risk

is the risk attributed to the operating cost structure, in particular the use of fixed costs in operations. The greater the fixed operating costs relative to variable operating costs, the greater the operating risk. Business risk is therefore the combination of sales risk and operating risk.

degree of total leverage (DTL)

looks at the combined effect of operating and financial leverage (i.e., it measures the sensitivity of net income to changes in units produced and sold).

sales risk

prices of the company's goods or services or the quantity of sales may be different from what is expected. We refer to the uncertainty with respect to the price and quantity of goods and services as sales risk.