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 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.
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).
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 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.
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 the relationship between Dol and DFL? ›
The relationship discovered between DOL and DFL is complex and manifold- first, it appears asymmetrical because DOL can influence DFL, but the former is unrelated to the latter. Second, there is an infra-annual relationship measurable through partial derivatives.
What is the difference between operating leverage and financial leverage PDF? ›
The utilisation of such resources and assets in the organisation's tasks for which it needs to pay fixed costs is known as operating leverage. The utilisation of obligation or debt in an organisation's capital design for which it needs to pay interest costs is known as financial leverage.
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 financial leverage in simple words? ›
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 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.
Operating leverage increases profitability and reduces optimal financial leverage.
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.
What happens if operating leverage is high? ›
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.
What are the disadvantages of operating leverage? ›
Operating leverage has its limitations that businesses need to consider. These limitations include limited flexibility, the presence of a break-even point, increased risk of losses, industry-specific factors, and the impact on profitability.
How to interpret operating leverage? ›
A lower operating leverage cost means more variable costs and reduced fixed costs, indicating that the company has to earn to break even. In comparison, a high operating leverage cost means more fixed costs and lower variable costs, indicating that the company already reaches break-even.
Why is operating leverage important? ›
Operating leverage, essentially, measures the proportion of fixed costs to your overall costs. Higher Operating Leverage means that you have more fixed costs in your cost structure. Lower operating leverage means that you have less fixed costs in your cost structure.
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.
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 DFL used for? ›
Dfl 6mg Tablet has anti-inflammatory and immunosuppressant properties. It is used for treating conditions like allergy diseases, anaphylaxis, asthma, rheumatoid arthritis, inflammatory skin diseases and autoimmune diseases (these diseases happen when your body's immune system attacks the body itself and causes damage).
What is the meaning of DFL? ›
The degree of financial leverage (DFL) is a ratio that measures the sensitivity of a company's net income to fluctuations or changes in capital structure.
