Business risk is usually defined in terms of variations of return (or profit) to a firm due to changes in activity resulting from changes in general economic activity. Can the degree of operating leverage therefore be described as a measure of business risk? Why?

Business risk is the uncertainty associated with the financial returns a firm might expect from its operations due to variables like market demand and economic shifts. It represents the chances of a business incurring losses instead of profits.

For instance, a company that depends heavily on seasonal products faces a high level of business risk during the off-season periods. This risk amplifies if the economic climate dampens consumer spending overall. The reason behind this is simple: when economy-wide spending shrinks, even the best of products can see a drop in sales, increasing the unpredictability of business performance.

Understanding business risk is crucial for management to steer a company through turbulent economic times. Determining ways to mitigate this risk, such as diversifying product lines or entering new markets, is essential. However, these strategies do not eliminate risk; they merely manage it.

Operating leverage is a financial tool that measures the proportion of fixed costs in a company’s cost structure and how it affects profitability with changes in sales volume. The higher the operating leverage, the greater the potential for magnified impacts on operating income from sales fluctuations.

This concept is best illustrated through an example: Consider a firm with high fixed costs and low variable costs. Even a modest increase in sales could result in a significant jump in operating income because the fixed costs are spread over more units. Conversely, a fall in sales would dramatically reduce operating income as the fixed costs remain unchanged.

Companies with high operating leverage are much like a lever in that a small movement (in sales) can cause a large force (in income changes), which points to high business risk.

Economic activity comprises all the actions that relate to the production, distribution, and consumption of goods and services in an economy. It is a critical driver of business results, as changes in general economic conditions can significantly affect a company's sales and profitability.

Diverse factors including GDP growth, employment rates, consumer confidence, and inflation can influence economic activity. A boom in economic activity usually yields higher consumer spending, thus more sales and profits for businesses. In contrast, during an economic slowdown, businesses must brace for reduced consumer spending, which directly impacts sales volume and subsequently, their bottom line.

The sensitivity of a company's operating income refers to how responsive this income is to changes in sales volume. A business with a high degree of operating leverage will see more significant changes in operating income with fluctuations in sales. This sensitivity is pivotal because it determines the financial robustness of a company in facing economic variances.

Typically, businesses measure this sensitivity for planning and to forecast how shifts in the market or general economy might impact their financial performance. Managers and analysts use it to anticipate changes in profitability and to make informed operational and investment decisions, which is indispensable in strategic financial planning.