Leverage, Volatility, and Financial Risk

Abstract

Financial risk is, in good measure, related to the uncertainty of profit coverage of interest payments and principal repayments. This note examines the effects of cyclical changes in volume on financial safety and on stockholder income and illustrates the factors that have more profound effects on income/risk considerations in a financial decision. The note is divided into three parts. The first section considers the impacts of leverage (both operating and financial), sales volatility, and growth on profits after taxes (a step away from shareholder income). The next part traces the relationship of these variables to burden coverage. These terms will be defined as appropriate. A final section illustrates financial risk from the equity shareholder's point of view. Excerpt UVA-F-0276 Leverage, Volatility, and Financial Risk Financial risk is, in good measure, related to the uncertainty of profit coverage of interest payments and principal repayments. This note examines the effects of cyclical changes in volume on financial safety and on stockholder income and illustrates the factors that have more profound effects on income/risk considerations in a financial decision. The note is divided into three parts. The first section considers the impacts of leverage (both operating and financial), sales volatility, and growth on profits after taxes (a step away from shareholder income). The next part traces the relationship of these variables to burden coverage. These terms will be defined as appropriate. A final section illustrates financial risk from the equity shareholder's point of view. Leverage, Volatility, and Profit Vulnerability Anyone familiar with the physical laws of leverage should have no trouble grasping the laws of financial leverage. However, the laws of financial leverage are rather loosely understood in practice. Most businesspeople are aware that financial leverage implies that a change in an input variable, such as sales, causes a magnified change in an output variable, such as earnings per share or market price. They also know that, when sales rise, leverage is beneficial, but it is damaging when sales decline. Finally, they know that the addition of fixed-income securities, such as debt, tends to increase leverage. Beyond these aspects, the leverage process tends to be mysterious. Most financial executives cannot describe very accurately the cause/effect properties of leverage as they affect financial decision making in their firms. Moreover, several prevailing concepts are not only erroneous, they are dangerous. Inasmuch as a clear understanding of the implications of the properties of leverage is important in working out proper debt policies for particular firms in their unique circumstances, this note will now set forth the principles of leverage. . . .