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Financial Leverage
Financial leverage affects the sensitivity of profits to a business by decreasing the level of profits retained by the business during downward economic cycles. During periods of economic expansion, the business is able to service the financial obligations with relative ease. However, since it is a fixed cost, the business may struggle to keep up with the payments during the period of depression (Bodie, Kane, & Marcus, 2013). As such, financial leverage increases the sensitivity of business profits for a business concern.
Operating leverage refers to the division between fixed costs and variable costs. The higher the fixed costs the business has, the greater the sensitivity the firm will have to business profits (Bodie, Kane, & Marcus, 2013, p. 391). During times of economic downturns, the businesses with more variable costs can achieve better margins than those with higher fixed costs owing to fewer swings and fixed operating leverage demands. Therefore, operating leverage affects the sensitivity to business profits.
Reference
Bodie, Z., Kane, A., & Marcus, A. J. (2013). Essentials of Investments. New York: McGraw-Hill/Irwin.
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