Question

According to a Chief Financial Officer of a listed company, she thinks that financial

leverage is more effective than operating leverage in the real world as one can use financial

derivatives to manage the risk accordingly. Do you agree with her? (Not more than 750

words)

Answer 1

The use of financial leverage varies greatly by industry and by the business sector. There are many industry sectors in which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility companies, and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by many companies in these sectors has played a paramount role in forcing a lot of them to file for Chapter 11 bankruptcy.

Operating leverage, on one hand, compares how well a firm uses its fixed costs and financial leverage, on the other hand, looks at various capital structures and chooses the one which reduces taxes most.

Effectiveness of both the leverages mainly depends upon type of industry.

If the industry deals mainly in finance then financial leverage is more effective there , but if it's a manufacturing industry then operating leverage will give more better results in decision making.