Leverage is the term which is commonly used to describe the organizations’ ability to utilize the assets which are having fixed costs (or) different sources of funds to increase the returns to the firm.
According to James Home, “Leverage is the employment of an asset or sources of funds for which the firm has to pay a fixed cost(operating cost) or fixed return(financial cost)”.
TYPES OF LEVERAGES
There are basically three types of Leverage:
- Operating Leverage- (OL)
- Financial Leverage- (FL)
- Combined Leverage- CL (Operating and financial)
In this article, we will see about Operating Leverage and Financial Leverage and also the differences and similarities between each of them.
Operating Leverage is defined as the firm’s ability to use the fixed operating costs to generate more revenue to the firm. Operating costs are divided into three types as Fixed costs(depreciation, insurance, etc.), variable costs(raw materials, labor costs,etc.), and semi-variable costs(electricity bills, fuel costs, etc).
The degree of Operating Leverage (DOL) is the measure to know the ratio of percentage change in operating income (EBIT) for a given percentage change in sales. The Degree of Operating Leverage is helpful in measuring the business risk of the firm.
Financial Leverage is the another type of leverage which is related to the financing decisions of the firm. Financial Leverage is defined as the ability of the firm to utilize the fixed financial charges so as to maximize the firms earning per share value.Financial Leverage is also known as “Trading as Equity”.
The degree of Financial Leverage (DFL) is the measure to know the ratio of percentage change in Earning per share (EPS) for a given percentage change in Operating Income(EBIT). The Degree of Financial Leverage is helpful in measuring the financial risk of the firm.
|OPERATING LEVERAGE||FINANCIAL LEVERAGE|
|Operating leverage is related to the firm’s operating cost structure.||Financial leverage is related to the firm’s capital structure.|
|Operating Leverage is helpful in measuring the business risk of the firm.||Financial Leverage is helpful in measuring the financial risk of the firm.|
|Operating Leverage calculates the operating risk associated with the mix of variable and fixed operating expenses.||Financial Leverage calculates the financial risk associated with the choice of sources of funds for financing the business.|
|Operating Leverage is determined by the relationship between Sales revenue and EBIT (Operating Income) of the firm.||Financial Leverage is determined by the relationship between EBIT (Operating Income) and EPS (Earning Per Share) of the firm.|
|Operating Leverage may be favorable or unfavorable to the organization.||Financial Leverage may be positive or negative to the earnings of the organization.|
|Impact when Higher|
|Higher Degree of Operating Leverage (DOL) shows the higher degree of Business risk to the firm.||Higher Degree of Financial Leverage (DFL) shows the higher degree of Financial risk of the firm.|
|Impact when Lower|
|Lower Degree of Operating Leverage (DOL) is the situation in which the firm's sales revenues are more when compared to the operating costs.||Higher Degree of Operating Leverage (DFL) is the situation in which the firm earns more from the assets purchased with the funds than the cost of funds.|
|Meaning of Risk|
|Operating Risk is the risk of the company not being able to meet the fixed operating cost requirements.||Financial Risk is the risk of the company not being able to meet the fixed financial cost requirements.|
|There is a direct relation between operating profit and Break Even Point (BEP). The Degree of Operating Leverage is usually higher near BEP.||The financial leverage is concerned with the liabilities side of the balance sheet where different sources of capital is shown.|
In the Leverage analysis, the main focus is on the measurement of the relationship between the two variables rather than measuring the variables. The measurement of leverages is the technique used by the business firms to measure the Risk – Return relationship of the firm operating and financial activities.