A credit analyst is assessing the creditworthiness of a manufacturing company. The analyst notes that the company has a high proportion of variable costs relative to fixed costs. How would this characteristic likely influence the company's credit risk profile, particularly during an economic downturn?
- AIt would increase credit risk due to reduced flexibility in cost adjustments.
- BIt would decrease credit risk due to lower operating leverage.
- CIt would increase credit risk due to higher operating leverage.
- DIt would decrease credit risk due to higher breakeven sales volume.
Show answer & explanationAnswer & explanation
Correct answer: B. It would decrease credit risk due to lower operating leverage.
A high proportion of variable costs relative to fixed costs implies lower operating leverage. During an economic downturn, lower operating leverage means that a decline in sales will result in a less severe decline in operating income, as variable costs will also fall proportionally with sales. This reduces the volatility of earnings and thus decreases credit risk.
Why the other options are wrong
- A. High variable costs provide greater, not reduced, flexibility in cost adjustments during downturns.
- C. High variable costs imply lower, not higher, operating leverage, which reduces credit risk.
- D. High variable costs typically lead to a lower, not higher, breakeven sales volume, making it easier to cover costs.
Operating Leverage and Credit Risk
Operating leverage measures how sensitive a company's operating income is to changes in sales volume. A higher proportion of fixed costs leads to higher operating leverage, making earnings more volatile and increasing credit risk, especially during downturns.
- Operating leverage = % Change in Operating Income / % Change in Sales.
- High fixed costs = high operating leverage.
- High variable costs = low operating leverage.
- Lower operating leverage generally indicates lower credit risk due to more stable earnings.
Memory trick: Fixed costs are a Fixed burden, Variable costs allow you to Vary.