Question

when we say a company has greater "Operating Leverage" than its competitor, we mean...

1) the company has a higher market share

2) the company has a higher ratio of fixed costs to variable costs

3) the company has a higher debt/assets ratio

4) the company has a higher debt/equity ratio

5) the company has a higher intrest coverage ratio

Answer 1

Solution:-

Operating leverage refers to the risk a business carries to its level of fixed costs. Every business sells a product or services which has a direct variable cost. The selling price adjusted for the direct variable cost of the product sold is the gross profit of the company. The direct variable costs are incurred only for the units that were sold, and therefore would go up or down based on the revenue generated. Out of the gross profit, the company has to cover its fixed costs such as factory rent, salaries, administrative expenses, etc and the amount remaining after that is the operating profit of the business.

If a business's fixed costs are higher, the business would need to make higher gross profits (by selling higher number of units) to cover the fixed costs and become profitable. While if the level of fixed costs are lower, the business wouldn't necessarily need to sell as much units to cover fixed costs and be profitable.

Therefore, this risk to business's profitability that arises due to the level of fixed costs is known as operating leverage. A business which has higher fixed costs to variable cost ratio has a higher operating leverage whereas a business with lower fixed cost to variable cost ratio has lower operating leverage.

Based on above explanation, the correct option is the second option.