It has is seen that financial leverage magnifies the shareholder’s earnings. It has also been observed that the variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. That is, with more debt, EPS rises and falls faster than the rise and fall of EBIT. Thus, financial leverage not only magnifies EPS but also increases its variability.
The variability of EBIT and EPS distinguish between two types of risk- operating risk and financial risk.
1. Operating Risk- Operating risk can be defined as the variability of EBIT (or return on assets). The environment- internal and external- in which a firm operates determines the variability of EBIT. So long as the environment is given to the firm, operating risk is an unavoidable risk. A firm is better placed to face such risk if it can predict it with a fair degree of accuracy.
The variability of EBIT has two components:
- Variability of sales
- Variability of expense
- Variability of sales- The variability of sales revenue is in fact, a major determinant of operating risk. Sales of a company may fluctuate because of two reasons. First, certain events affect the sales of companies belonging to a particular industry. For example, the general economic conditions may be hit by the recession. Other factors may include the availability of raw materials, technological changes, actions of competitors, industrial relations, shifts in consumer preferences, and so on. Second, sales may also be affected by the factors, which are internal to the company. The change in management, the product- the changes in general economic conditions may affect the level of business activity. market decisions of the company and its investment policy, or strike in the company have a great influence on the company’s sales.
- Variability of Expenses- Given the variability of sales, the variability of EBIT is further affected by the composition of fixed and variable expenses. Higher the proportion of fixed expenses relative to variable expenses, the higher the degree of operating leverage. High operating leverage leads to a faster increase in EBIT when sales are rising. In bad times when sales are falling, high operating leverage becomes a nuisance; EBIT declines at a greater rate than a fall in sales. Operating leverage causes wide fluctuations in EBIT with varying sales. Operating expenses may also vary on account of changes in input prices, and may also contribute to the variability of EBIT.
2. Financial Risk- For a given degree of variability of EBIT, the variability of EPS (and ROE) increases with more financial leverage. The variability of EPS caused by the use of financial leverage is called financial risk. Firms exposed to the same degree of operating risk can differ with respect to financial risk when they finance their assets differently. Financial risk is thus an avoidable risk if the firm decides not to use any debt in its capital structure.