Operating leverage and financial leverage are two different metrics used to determine the financial health of a company.
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.
Key Takeaways
- Operating leverage and financial leverage both tell you different things about a company's financial health.
- Operating leverage is an indication of how a company's costs are structured and also is used to determine its breakeven point.
- Financial leverage refers to the amount of debt used to finance the operations of a company.
Operating Leverage and Fixed Costs
Operating leverage measures the extent to which a company or specific project requires some aggregate of both fixed and variable costs. Fixed costs are those costs or expenses that do not fluctuate regardless of the number of sales generated by a company. Some examples of fixed costs include:
- salaries
- rent
- utilities
- interest expense
- depreciation
Operating Leverage and Variable Costs
Variable costs are expenses that vary in direct relationship to a company’s production. Variable costs rise when production increases and fall when production decreases. For example, inventory and raw materials are variable costs while salaries for the corporate office would be a fixed cost.
Operating leverage can help companies determine what their breakeven point is for profitability. In other words, the point where the profit generated from sales covers both the fixed costs as well as the variable costs.
A manufacturing company might have high operating leverage because it must maintain the plant and equipment needed for operations. On the other hand, a consulting company has fewer fixed assets such as equipment and would, therefore, have low operating leverage.
Using a higher degree of operating leverage can increase the risk of cash flow problems resulting from errors in forecasts of future sales.
Financial Leverage Explained
Financial leverage is a metric that shows how much a company uses debt to finance its operations. A company with a high level of leverage needs profits and revenue that are high enough to compensate for the additional debt it shows on its balance sheet.
Investors look at a company's leverage because it is an indicator of the solvency of the company. Also, debt can help magnify earnings and earnings per share. However, there is a cost associated with leverage in the form of interest expense.
When a company's revenues and profits are on the rise, leverage works well for a company and investors. However, when revenues or profits are pressured or falling, the debt and interest expense must still be paid and can become problematic if there is not enough revenue to meet debt and operational obligations.
FAQs
Operating leverage is an indication of how a company's costs are structured and also is used to determine its breakeven point. Financial leverage refers to the amount of debt used to finance the operations of a company.
What is the difference between operating leverage and financial leverage? ›
Financial leverage measures how changes in earnings before interest and taxes (EBIT) affect net income. Operating leverage, on the other hand, measures how changes in sales volume affect operating profit.
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 leverage ratio? ›
On the balance sheet, leverage ratios are used to measure the amount of reliance a company has on creditors to fund its operation. The financial leverage of a company is the proportion of debt in the capital structure of a company as opposed to equity.
What is operating leverage in simple words? ›
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 is meant 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 leverage in simple words? ›
to use something that you already have in order to achieve something new or better: We can gain a market advantage by leveraging our network of partners. SMART Vocabulary: related words and phrases.
What is the difference between margin and leverage with example? ›
Leverage is often expressed as a ratio (5:1 or 10:1) or as a multiple (5x or 10x). In the case of a 5x or 5:1 leverage, your purchasing power would be five times that of the amount you deposit as a margin. For instance, you can enter into a position as large as ₹25,000 by depositing a margin of just ₹5,000.
What is the difference between margin and operating margin? ›
Gross profit margin includes the direct costs involved in production, while operating profit margin accounts for operating expenses like overhead.
Is operating leverage good or bad? ›
If a business has a high degree of operating leverage, it's a reliable indication that its proportion of fixed to variable costs is high. As such, the business is using more fixed assets to support its core business. Ultimately, this means that the business will be able to expand its profit margin more quickly.
The use of debt, also known as leverage, can be a positive indicator of a company's health when future benefits are expected to compensate for the current debt. The problem is when debt becomes excessive and harms the funds needed to properly run a business.
What is the difference between financial risk and financial leverage? ›
Financial leverage refers to the use of debt financing to increase the potential returns on investment, while financial risk refers to the risk that a company may not be able to meet its financial obligations due to factors such as changes in interest rates, market conditions, or its financial structure.
What are two main leverage ratios? ›
Below is an illustration of two common leverage ratios: debt/equity and debt/capital.
What is the difference between operating and financial leverage? ›
Operating leverage can be defined as a firm's ability to use fixed costs (or expenses) to generate better returns for the firm. Financial leverage can be defined as a firm's ability to increase better returns and reduce the firm's cost by paying less taxes.
How to calculate operating leverage and financial leverage? ›
Meaning of Financial Leverage:
- The formula to calculate the degree of financial Leverage is.
- DFL = % Change in EPS / % Change in EBIT.
- DFL = EBIT/ EBT.
- The formula to compute the degree of operating leverage is.
- DOL = % Change in EBIT / %Change in Sales.
- DOL = Contribution / EBIT.
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 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).
Is it better to have high financial leverage or high operating leverage? ›
High operating leverage means a company has high fixed costs relative to variable costs. This leads to higher volatility in earnings. Even a small drop in sales can lead to a big drop in profits due to the high fixed costs. Low financial leverage means a company has lower debt levels and interest expenses.
What is operating leverage from financial statements? ›
Operating Leverage tells you how much of a company's expenses are fixed (i.e., they do not change with production volume) vs. variable (i.e., they do change with production volume); higher operating leverage means that as sales grow, more of these sales “trickle down” into a company's Operating Income.
