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.

  1. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  2. Are there leveraged ETFs that follow the retail sector?

    There are many exchange-traded funds (ETFs) that track the retail sector or elements of the retail sector, and some of those ... Read Full Answer >>
  3. What are some common cash-debt strategies that occur during a spinoff?

    Cash-debt strategies that are commonly used to in a spinoff to enable the parent company to monetize the spinoff are debt/equity ... Read Full Answer >>
  4. What are the similarities and differences between the savings and loan (S&L) crisis ...

    The savings and loan crisis and the subprime mortgage crisis both began with banks creating new profit centers following ... Read Full Answer >>
  5. How can I determine the degree of financial leverage (DFL) for a particular company?

    Fundamental analysis uses the degree of operating leverage (DFL) to determine the sensitivity of a company's earnings per ... Read Full Answer >>
  6. Why should investors be wary of off balance sheet financing activities?

    Investors should be wary of companies that rely heavily on off-balance-sheet financing because it may make those businesses ... Read Full Answer >>
Related Articles
  1. Stock Analysis

    Coca-Cola Vs. PepsiCo: Which Stock Should You Buy?

    Learn about the bull case for Coca-Cola and PepsiCo. Find out which is more attractive for investors, and learn about the strengths of each company.
  2. Mutual Funds & ETFs

    ETF Analysis: Direxion Daily Financial Bull 3X

    Obtain a thorough review and analysis of the Direxion Daily Financial Bull 3X fund, a leveraged ETF that tracks the performance of the financial sector.
  3. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
  4. Stock Analysis

    How Rollins Inc. Transformed from Radio to Pest Control

    Discover how Rollins, Inc. grew and expanded, making numerous acquisitions, transitioning from the radio industry to the pest control industry.
  5. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  6. Technical Indicators

    Key Financial Ratios to Analyze Investment Banks

    Find out which financial ratios are most useful when analyzing an investment bank, and why tracking capital efficiency is especially important.
  7. Professionals

    Career Advice: Management Consulting Vs. Private Equity

    Compare the career paths of management consulting and private equity, using criteria such as skills needed, starting salary and work-life balance.
  8. Trading Strategies

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  9. Brokers

    10 Most Famous Public Companies That Went Private

    Here’s a list of the most popular listed companies that went private in recent decades.
  10. Mutual Funds & ETFs

    ETF Analysis: Direxion Small Cap Bull 3X

    Read about a triple-leveraged exchange-traded fund that aims for 300% of the returns of the Russell 2000 Index: the Direxion Small Cap Bull 3X.
  1. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin ...
  2. Equity

    Equity is the value of an asset less the value of all liabilities ...
  3. Debt/Equity Ratio

    Debt/Equity Ratio is debt ratio used to measure a company's financial ...
  4. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  5. Ceded Reinsurance Leverage

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

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

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!