Operating Leverage risks.

Operating Leverage risks.

The cost of business comprises of the variable and the fixed costs. These costs influence the marginal production costs. Additionally, different combinations of variable and fixed costs result in operating leverage (Roth et al., 2015). The ratio of these two costs determined the amount a company would employ as operating leverage. An organization that possesses a high ratio is likely to have high operating leverage. However, when the variable costs exceed the fixed costs, the company is likely to have a smaller proportion. Hence, it would employ less operating leverage.  

Additionally, when a Company finances it’s assets by using debt, then they would be a rise in financial leverage. Most organizations use this strategy in cases where they would not be able to raise adequate capital (Roth et al., 2015). The debts then become a liability for the firm, which it would need to pay additional interest costs. It is thus, advisable for a firm to take on take debt that whose interest would be lower than the return on assets.

Therefore, an organization that operates its activities with financial and operating leverages does a risky business. The high operating leverages indicate that the Company makes few sales with higher margins. Hence, it is dangerous in a case where the firm is not able to estimate the future sales correctly. Predicting slightly higher sales in the future would cause a huge gap between the budgeted cash flow and the actual cost. Hence would affect the operating of the firm in the future. 

Reference. 

Roth, A., Gray, J., Shockley, J., & Weng, H. H. R. (2015). The use of secondary source data for measuring performance in operations management research.