Every business carries some business risk. On which of the following does the business risk of a firm depend?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → The level of its fixed operating costs
Option (1) The proportion of debt in its total capital — Incorrect. The share of debt in the total capital decides the financial risk of the firm, because debt brings interest and repayment that must be paid.
Option (2) The level of its fixed operating costs — Correct. Apart from financial risk, every business has an operating risk, also called business risk. Business risk depends upon fixed operating costs: the higher these costs, the higher the business risk.
Option (3) The fixed financial charges it has to pay — Incorrect. Fixed financial charges are interest, preference dividend and repayment. Being unable to meet them is financial risk, which comes from the use of debt.
Option (4) The return on investment it earns — Incorrect. RoI decides whether a firm can use trading on equity to raise its EPS. A higher RoI means a greater ability to use debt. It shows how well the firm earns, but business risk itself comes from fixed operating costs.
Business risk comes from fixed operating costs, and financial risk comes from fixed financial charges; the total risk of a firm depends upon both.
NCERT (2026-27 Edition): “9. Risk Consideration: As discussed earlier, use of debt increases the financial risk of a business. Financial risk refers to a position when a company is unable to meet its fixed financial charges namely interest payment, preference dividend and repayment obligations. Apart from the financial risk, every business has some operating risk (also called business risk). Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. The total risk depends upon both the business risk and the financial risk. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.” “Financing Decision … Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity. There is no such compulsion to pay any dividend on equity shares. Thus, there is some amount of financial risk in debt financing. The overall financial risk depends upon the proportion of debt in the total capital. …” |