Both investors and companies employ leverage (borrowed capital) when attempting to generate greater returns on their assets. However, using leverage does not guarantee success, and possible excessive losses are more likely from highly leveraged positions.
Leverage is used as a funding source when investing to expand a firm's asset base and generate returns on risk capital; it is aninvestment strategy.Leverage can also refer to the amount of debt a firm uses to finance assets. If a firm is described as highly leveraged, the firm has more debt than equity.
For companies, two basic types of leverage can be used: operating leverage and financial leverage.
Key Takeaways
- Companies take on debt, known as leverage, in order to fund operations and growth as part of their capital structure.
- Debt is often favorable to issuing equity capital, but too much debt can increase the risk of default or even bankruptcy.
- Operating leverage and financial leverage are two key metrics that investors should analyze to understand the relative amount of debt a firm has and if they can service it.
Operating Leverage
Operating leverage is the result of different combinations of fixed costs and variable costs. Specifically, the ratio of fixed and variable costs that a company uses determines the amount of operating leverage employed. A company with a greater ratio of fixed to variable costs is said to be using more operating leverage.
If a company's variable costs are higher than its fixed costs, the company is using less operating leverage. How a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is highly leveraged. On the other hand, a firm with a high volume of sales and lower margins are less leveraged.
Although interconnected because both involve borrowing, leverage and margin are different. While leverage is the taking on of debt, marginis debt or borrowed money a firm usesto invest in other financial instruments. For example, a margin account allows an investor to borrow money at a fixed interest rate to purchase securities, options, or futures contracts in the anticipation that there will be substantially high returns.
Financial Leverage
Financial leverage arises when a firm decides to finance the majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs. If a firm needs capital, it will seek loans, lines of credit, and other financing options.
When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that debt. A company will only take on significant amounts of debt when it believes that return on assets (ROA) will be higher than the interest on the loan.
Outcomes
A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than the actual, this could lead to a huge discrepancy between actual and budgeted cash flow, which will have a significant effect on a firm's future operating ability.
The biggest risk that arises from high financial leverage occurs when a company's return on ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.
FAQs
Operating leverage is the name given to the impact on operating income of a change in the level of output. Financial leverage is the name given to the impact on returns of a change in the extent to which the firm's assets are financed with borrowed money.
How is financial leverage different from operating leverage? ›
Operating leverage is an indication of how a company's costs are structured. The metric is used to determine a company's breakeven point, which is when revenue from sales covers both the fixed and variable costs of production. Financial leverage refers to the amount of debt used to finance the operations of a company.
What is operating leverage? ›
What Is Operating Leverage? Operating leverage is a cost-accounting formula (a financial ratio) that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.
What do you mean by financial leverage? ›
Financial leverage is the use of borrowed money (debt) 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.
What is the difference between Dol and DFL? ›
Degree of Operating Leverage (DOL): The greater the DOL, the more sensitive operating income (EBIT) is to changes in sales. Degree of Financing Leverage (DFL): The higher the DFL, the more sensitive that net income is to changes in operating income (EBIT).
Which is better operating leverage or financial leverage? ›
The answer is yes. If a company can use its fixed costs well, it would be able to generate better returns just by using operating leverage. And at the same time, they can use financial leverage by changing their capital structure from total equity to 50-50, 60-40, or 70-30 equity-debt proportion.
Is it better to have high financial leverage or high operating leverage? ›
Most investors, such as private equity firms and venture capitalists, prefer companies with high operating leverage because it makes growth faster and easier.
What is an example of a financial leverage? ›
An example of financial leverage is buying a rental property. If the investor only puts 20% down, they borrow the remaining 80% of the cost to acquire the property from a lender. Then, the investor attempts to rent the property out, using rental income to pay the principal and debt due each month.
Is operating leverage good or bad? ›
Generally speaking, high operating leverage is better than low operating leverage, as it allows businesses to earn large profits on each incremental sale. Having said that, companies with a low degree of operating leverage may find it easier to earn a profit when dealing with a lower level of sales.
Why is operating leverage risky? ›
A firm that operates with both high operating and financial leverage can be a risky investment. High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales.
You can calculate a business's financial leverage ratio by dividing its total assets by its total equity. To get the total current assets of a company, you'll need to add all its current and non-current assets.
What are the advantages of financial leverage? ›
Advantages of leverage include access to additional funds. A corporate entity can purchase more assets with the help of leveraged funds. It will help the company to enhance the returns on its assets. The returns generated from the assets can be used to pay off the debt.
Is it better to have a higher or lower DOL? ›
When businesses with a low DOL sell more product, they'll have higher variable costs, so operating income won't rise as dramatically as it would for a company with a high DOL and fewer variable costs.
Is DOL a measure of financial risk? ›
The degree of operating leverage (DOL) is a financial ratio that measures the sensitivity of a company's operating income to its sales. This financial metric shows how a change in the company's sales will affect its operating income.
Should DFL be high or low? ›
The higher the DFL, the more volatile earnings per share (EPS) will be. Since interest is a fixed expense, leverage magnifies returns and EPS, which is good when operating income is rising but can be a problem during tough economic times when operating income is under pressure.
What is the difference between operating margin and leverage? ›
Leverage allows you to trade a larger financial position with a smaller sum. Margin, on the other hand, is the initial investment you need to make to open a leveraged trade. Combined, margin and leverage allow you to leverage the funds in your account to potentially generate larger profits than your initial investment.
What is the difference between financial leverage and capital structure? ›
Financial leverage involves the use of debt to magnify returns and risk, while operating leverage focuses on the impact of fixed costs on profitability. The choice of capital structure depends on a company's specific circ*mstances and goals, aiming to balance risk and return to create value for shareholders.
Is operating leverage the same as degree of operating leverage? ›
The DOL ratio helps analysts determine what the impact of any change in sales will be on the company's earnings. Operating leverage measures a company's fixed costs as a percentage of its total costs.
