Definition
Operating leverage refers to a company’s use of fixed costs in its operations to magnify returns and enhance profitability. Conversely, financial leverage involves the use of borrowed funds or debt to increase the potential returns to the investor or shareholder. While both can increase profits when business is good, they can also exacerbate losses if business conditions deteriorate.
Key Takeaways
- Operating leverage refers to the company’s fixed operational costs, whereas financial leverage relates to the debt used to finance the company’s operations. While operating leverage shows how well a company can use its fixed costs to generate profits, financial leverage indicates how much of the company’s assets are financed by debt.
- High degrees of operating leverage mean the company has higher fixed costs and can, therefore, achieve higher profits with increases in sales. On the other hand, high financial leverage indicates that the company has more debt, which could lead to higher earnings per share or potentially increase the risk of bankruptcy if the company cannot meet its financial obligations.
- The main risk of operating leverage is that if sales decrease, it will be difficult to cover fixed costs, leading potentially to losses. For financial leverage, the risk lies in the pressure to generate enough returns to meet debt obligations. As such, both types of leverage can significantly impact a company’s profitability and financial stability.
Importance
Operating leverage and financial leverage are significant finance terms that help corporations in strategic financial decisions making. Operating leverage measures the extent to which a company uses fixed costs in its operations.
High operating leverage indicates that a significant portion of the company’s costs are fixed, which leads to higher profits from increasing sales but also higher risks if sales decrease. On the other hand, financial leverage measures how much of the company’s capital structure is made up of debt or other financial obligations.
High financial leverage indicates greater reliance on debt, which increases the company’s potential returns but also increases its risk of insolvency or financial distress. Thus, understanding the concepts of operating leverage and financial leverage is crucial for companies to balance growth, risk, and profitability effectively.
Explanation
Operating leverage and financial leverage are both essential instruments used by management to understand the risk and return of a company. Operating leverage refers to the company’s ability to use its operating costs to its advantage. A company with high operating leverage has a significant proportion of its costs linked with fixed costs rather than variable costs.
Such a company is well-positioned to generate higher profits with an increase in the volume of output, as fixed costs don’t change with the volume of production. It’s mainly used to evaluate the business’s break-even point, the level at which it covers all its operating expenses and starts making profits. On the other hand, financial leverage is the extent to which a company uses debt to finance its assets.
Companies with high financial leverage are those that rely more on borrowed funds than equity. This leverage is primarily used to finance the company’s operations, expand the production base or for other profitable investments. The purpose of financial leverage is to increase the potential return on equity, but it also increases the risk since the company has to meet its debt obligations regardless of its earning condition.
Both operating leverage and financial leverage are essential for better financial management, profitability analysis, and strategic planning of an organization.
Examples of Operating Leverage vs Financial Leverage
Sure, I’ll provide some examples to illustrate how operating and financial leverage might be used in actual businesses:
Operating Leverage Example: A manufacturing company invests heavily in automated machinery to produce its goods. This increases fixed costs due to depreciation, but decreases variable costs because they need fewer workers and and have less manual labor costs. This is high operating leverage because their breakeven point is higher due to the high fixed costs, but above the breakeven point, their profits increase at a faster rate due to lower variable costs per unit.
Financial Leverage Example: A real estate company takes out a mortgage to purchase a large office building. The mortgage forms a significant portion of the company’s capital structure, meaning the firm has high financial leverage. As a result, the firm is exposed to a high level of financial risk due to the debt requirement. However, if the office building generates enough rental income to cover the interest payments and leaves a surplus, the firm’s return on equity can be higher than if it had entirely purchased the property with equity.
Composite Example (both Operating and Financial Leverage): An airline company that leases its entire fleet of aircraft is employing both operating and financial leverage. The leasing cost of aircraft is a fixed cost, increasing operating leverage, while the leasing commitment itself is a form of debt, because it’s a financial obligation regardless of the company’s profitability, highlighting the use of financial leverage. If passenger numbers increase significantly, the company will substantially increase its profitability due to the operating leverage. However, if the company goes through a difficult time (like during a pandemic), it may struggle to cover its lease payments, putting it under financial risk due to its financial leverage.
FAQ: Operating Leverage vs Financial Leverage
Q1: What is Operating Leverage?
A1: Operating leverage is used to quantify how a firm’s operations can increase its profitability by increasing its sales, prior to any financial costs such as interest, tax, and so on. Essentially, it measures a company’s ability to increase profit with increased sales.
Q2: What is Financial Leverage?
A2: Financial leverage refers to the amount of borrowed money a company utilizes to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing. It uses debt financing to increase the return on equity and generate profit.
Q3: How does Operating Leverage work?
A3: Operating leverage increases as a firm expands its fixed costs in relation to its variable costs. If a company has high operating leverage, it has high fixed costs and low variable costs, which means it can generate more profit from each additional unit of sales.
Q4: How does Financial Leverage work?
A4: Financial leverage works by allowing companies to use borrowed funds to acquire additional assets. When the income generated from these assets exceeds the cost of borrowing, this results in higher earnings per share for shareholders – enhancing the return on equity.
Q5: What are the risks involved with Operating and Financial Leverage?
A5: Both types of leverage come with their own set of risks. High operating leverage can lead to significant losses if a company cannot generate enough sales to cover its fixed costs. On the other hand, high financial leverage can lead to high interest payments which can impact profitability and risk insolvency if a company is unable to meet its financial obligations.
Related Entrepreneurship Terms
- Fixed costs
- Earnings before Interest and Tax (EBIT)
- Debt Financing
- Operating Income
- Equity Capital
