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What does the degree of leverage measure?

  1. The ratio of fixed to variable costs

  2. The effect of sales changes on earnings

  3. The total debt relative to equity

  4. The liquidity of cash and cash equivalents

The correct answer is: The effect of sales changes on earnings

The degree of leverage, specifically known as operating leverage and financial leverage, measures how changes in sales volume affect a company's earnings before interest and taxes (EBIT). When a company has high operating leverage, a small increase in sales can lead to a significant increase in earnings due to the fixed costs involved in production. Conversely, if sales decline, those fixed costs remain, leading to a sharper decline in earnings. This relationship highlights how sensitive a company's profitability is to changes in its sales volume, which is crucial for assessing risk and making strategic decisions. The correct choice reflects this concept clearly, demonstrating how leverage amplifies the effects of sales fluctuations on earnings. The other options address different financial metrics. The ratio of fixed to variable costs pertains more to cost structure analysis rather than leverage. The total debt relative to equity refers to the debt-to-equity ratio, which assesses a company's financial structure and risk but not the operational impact of sales changes on earnings. Liquidity of cash and cash equivalents focuses on the company's ability to meet short-term obligations, not on leverage. Understanding these distinctions helps clarify the role of leverage in financial analysis and decision-making.