Question

The degree of financial leverage for ABC Inc. is 2.5, and the degree of financial leverage for XYZ Corporation is 1.5. According to this information, which firm is considered to have greater financial risk?
a. ABC Inc.
b. XYZ Corporation.
c. The degree of financial leverage is not a measure of financial risk, so it is not possible to tell which firm has the greater financial risk given the above information.
d. To determine which firm has the greater financial risk, we need to know the operating income (NOI or EBIT) of each firm. XYZ Corporation would have less financial risk if its operating income is at least twice that of ABC Inc.
e. None of the above is the correct answer.

Answer 1

Answer:

a. ABC Inc.

Explanation:

The degree of financial leverage is expressed by the following formula,

= $\frac{EBIT}{EBT}$

The ratio represents the relationship between net operating profits and profits after financial fixed costs.

Higher the degree of financial leverage, higher will be the financial risk.

In the given case, ABC Inc.'s degree of financial leverage is higher which suggests that ABC has employed more of debt in it's financial structure owing to which higher fixed cost obligations in the form of interest payments have been created.

Thus, ABC Inc. will have a greater financial risk.