If a firm has high financial and operating leverage, what is the implication?

When a firm has high financial and operating leverage, it means that a larger portion of its costs are fixed rather than variable. Operating leverage refers to the proportion of fixed costs in a firm's cost structure, which means that as sales change, fixed costs do not change in response. Financial leverage indicates the extent to which a firm uses debt in its capital structure, leading to fixed interest obligations that also do not vary with sales.

As sales fluctuate, firms with high leverage (both operational and financial) will experience greater variability in profits. This occurs because any increase in sales leads to a more than proportional increase in profits due to the fixed costs being spread over a larger volume of sales. Conversely, in the event of declining sales, the fixed costs remain unchanged while revenue falls, resulting in a sharper decline in profits.

Thus, firms with high leverage are more sensitive to changes in sales, making their profits more volatile. Therefore, the implication of high financial and operating leverage is that profits will be more volatile as sales fluctuate.