What are the risks of having both high operating leverage and high financial leverage?

A:

In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their assets. However, using leverage does not guarantee success, and the possibility of excessive losses is greatly enhanced in highly leveraged positions. For companies, there are two types of leverage that can be used: operating leverage and financial leverage.

Operating leverage relates to 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 said to be using less operating leverage. The way that a business makes sales is also a factor in how much leverage it employs. A firm with few sales and high margins is said to be highly leveraged. On the other hand, a firm with a high volume of sales and lower margins is said to be less leveraged.

Financial leverage arises when a firm decides to finance a 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. When a firm takes on debt, it becomes a liability on which it must pay interest. 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.

A firm that operates with both high operating and financial leverage makes for a risky investment. A high operating leverage means 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 what actually occurs, this could lead to a huge difference between actual and budgeted cash flow, which will greatly affect a firm's future operating ability. The biggest risk that arises from high financial leverage occurs when a company's ROA does not exceed the interest on the loan, which greatly diminishes a company's return on equity and profitability.

To learn more, see Introduction To Fundamental Analysis, Understanding The Subtleties Of ROA Vs. ROE and When Companies Borrow Money.

RELATED FAQS

  1. What is liquidity risk?

    Learn how to distinguish between the two broad types of financial liquidity risk: funding liquidity risk and market liquidity ...
  2. What does the gearing ratio say about risk?

    Find out why lenders and investors pay close attention to a firm's gearing ratios, and why both too much and too little borrowing ...
  3. How do hedge funds determine what assets to own?

    Learn about the various types of investments that hedge fund managers use, and explore basic hedge fund management trading ...
  4. Which leverage ratios are most useful for analyzing manufacturing companies?

    See which leverage ratios investors and creditors are likely to use when analyzing the debt burdens for manufacturing companies.
RELATED TERMS
  1. Ceded Reinsurance Leverage

    The ratio of ceded insurance balances to policyholders’ surplus. ...
  2. Total Debt-to-Capitalization Ratio

    An indicator that measures the total amount of debt in a company’s ...
  3. Leveraged Buyback

    A repurchase of significant amount of shares through the use ...
  4. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  5. Capitalization Ratios

    Indicators that measure the proportion of debt in a company’s ...
  6. Cash Flow-to-Debt Ratio

    A ratio of a company’s cash flow from operations to its total ...

You May Also Like

Related Articles
  1. Active Trading Fundamentals

    Introduction to Margin Accounts

  2. Investing Basics

    Picking Your First Broker

  3. Fundamental Analysis

    6 Dangerous Moves For First-Time Investors

  4. Home & Auto

    Leveraging Leverage For Bigger Profits

  5. Fundamental Analysis

    Take On Risk With A Margin of Safety

Trading Center