Does operating leverage increase firm's profitability and bankruptcy risk? Evidence from China's entry into WTO

Abstract

This study tests the relationship among operating leverage, profitability and financial leverage. Operating leverage boosts profitability and cuts down the optimal financial leverage of the firm. Therefore, operating leverage renders a negative relationship between profitability and financial leverage that is inconsistent with the static trade‐off theory. By considering WTO and using data of export manufacturing firms in China for the period 1990–2018, our results indicate that operating leverage and profitability have a positive relationship, and operating leverage is a central cause to create an inverse correlation between profitability and financial leverage when firm's revenue declines. In addition, operating and financial leverages have substitutions effect when the firm operating cost is quasi‐fixed. Furthermore, the firm's bankruptcy risk is linked with higher operating leverage. Our study suggests that firms should consider both operating and financial leverage to maximize their profitability because the preference of one leverage on the other increases bankruptcy risk, and operating leverage preference creates an inverse correlation between profitability and financial leverage.