What is meant by ‘Operating Leverage’ and ‘Financial Leverage’?

Operating leverage and financial leverage are two concepts used in finance to describe the impact of fixed costs on a company's profitability and risk.

1. Operating Leverage:

   • Operating leverage refers to the degree to which a company's fixed costs, such as rent, depreciation, and salaries, affect its operating income or earnings before interest and taxes (EBIT). A company with high operating leverage has a higher proportion of fixed costs relative to variable costs.

   • When a company has high operating leverage, small changes in sales volume can lead to disproportionately larger changes in operating income. This is because fixed costs remain constant regardless of sales volume, causing operating income to increase or decrease more rapidly with changes in sales.

   • Operating leverage can magnify both profits and losses. In periods of increasing sales, companies with high operating leverage can experience significant profit growth due to the economies of scale. However, in downturns or periods of declining sales, high operating leverage can amplify losses, as fixed costs become a larger proportion of total costs.

   • Operating leverage is often measured using the degree of operating leverage (DOL), which quantifies the percentage change in operating income for a given percentage change in sales.

2. Financial Leverage:

   • Financial leverage refers to the use of debt or other fixed-cost financing to increase the potential return on equity for shareholders. It involves using borrowed funds to finance investments or operations, with the goal of magnifying returns through the use of leverage.

   • By using debt financing, companies can increase their financial leverage, thereby increasing their return on equity (ROE) when the return on assets (ROA) exceeds the cost of debt. This is because debt financing allows companies to amplify profits through the use of other people's money (OPM).

   • However, financial leverage also increases the risk of financial distress, as companies have fixed interest payments that must be met regardless of their operating performance. High financial leverage can magnify both returns and losses for shareholders, depending on the company's profitability and ability to service its debt.

   • Financial leverage is often measured using financial leverage ratios such as the debt-to-equity ratio, which compares a company's debt to its equity capital.

In summary, operating leverage and financial leverage both describe the impact of fixed costs on a company's profitability and risk. Operating leverage relates to the impact of fixed costs on operating income, while financial leverage relates to the use of debt financing to magnify returns on equity. Both types of leverage can amplify profits but also increase the risk of losses for shareholders.