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 are the three types of leverage? ›
With various types of leverage available – financial, operating, and combined – businesses can adopt different strategies to achieve their goals.
What do you mean by financial leverage? ›
What is 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.
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 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 a good operating leverage ratio? ›
Using the cost structure formula, they calculate:100,000 (20 - 10) / 100,000 (20 - 10) - 10,000 = 1.1The degree of operating leverage is 1.1. This number means that for every 1% change in the company's sales, the company's operating income is expected to change by 1.1%.
How to calculate operating 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.
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.
There is a suite of financial ratios referred to as leverage ratios that analyze the level of indebtedness a company experiences against various assets. The two most common financial leverage ratios are debt-to-equity (total debt/total equity) and debt-to-assets (total debt/total assets).
What is the best way to explain leverage? ›
Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex trading. By borrowing money from a broker, investors can trade larger positions in a currency.
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 operating leverage in simple words? ›
Operating leverage measures a company's ability to increase its operating income by increasing its sales volume. As a cost accounting measure, it is used to analyze the proportion of a company's fixed versus variable costs.
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.
What is a good financial leverage? ›
A financial leverage ratio of less than 1 is usually considered good by industry standards. A leverage ratio higher than 1 can cause a company to be considered a risky investment by lenders and potential investors, while a financial leverage ratio higher than 2 is cause for concern.
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 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.
How does operating and financial leverage affect profit? ›
Similar to operating leverage, financial leverage can amplify profits when the company performs well. However, in lean periods, interest obligations can increase the risk of financial distress and potential bankruptcy. In good times, Scenario 4 with high operating and financial leverage provides the highest net income.
