Question：Financial gearing measures the proportion of long-term debt capital relative to equity finance. Operational gearing is a measure of contribution to the total costs of sales. (Contribution is sales minus the variable cost of sales.)
Which of the following is the highest-risk gearing profile for a company?
A. Debt capital is a low proportion of long-term debt and variable costs are a low proportion of the cost of sales and sales revenue.
B. Debt capital is a high proportion of long-term debt and variable costs are a high proportion of the cost of sales and sales revenue.
C. Debt capital is a high proportion of long-term debt and variable costs are a low proportion of the cost of sales and sales revenue.
D. Debt capital is a low proportion of long-term debt and variable costs are a high proportion of the cost of sales and sales revenue.
The correct answer is: Debt capital is a high proportion of long-term debt and variable costs are a low proportion of the cost of sales and sales revenue.
Risk is greater when financial gearing is higher. Risk is also greater when variable costs are a low proportion of cost of sales and revenue (i.e. contribution is a high proportion of sales), because any change in sales will have a relatively high impact on profits and earnings.
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