Operating leverage is an indication of how a company's costs are structured and is used to determine the break-even point for a company. Financial leverage refers to the amount of debt used to finance the operations of a company.
Operating leverage represents the percentage of total costs that are fixed costs for a company. Operating leverage measures the extent to which a company or specific project requires some aggregate of both fixed and variable costs. Fixed costs are those costs or expenses that don't fluctuate regardless of the number of sales being generated by a company.
Some examples of fixed costs include:
- interest expense,
Variable costs are those that vary in direct relationship to a company’s production. Variable costs rise when production increases and fall when production decreases. For example, inventory and raw materials would be variable costs while overhead for the corporate office would be a fixed cost.
Operating leverage can help companies determine their break-even point for profitability. In other words, the profit generated from sales needs to cover both their fixed costs as well as their variable costs. A company with high operating leverage has a higher percentage of their total costs as fixed costs. Companies with low operating leverage have a lower percentage of their total costs as fixed costs. A manufacturing company might have high operating leverage due to the plant and equipment needed to operate. On the other hand, a consulting company would have few fixed assets and would, therefore, have low operating leverage.
Financial leverage is a metric that shows how much a company uses debt to finance their operation. A company with high financial leverage should have increased profits and revenue to compensate for the additional debt.
Investors need to beware of a company's financial leverage since it's an indicator as to the solvency of the company. Financial leverage can help magnify earnings and earnings per share. However, there is a cost associated with leverage in the form of interest expense. When a company's revenues and profits are on the rise, leverage works well for a company and investors. However, when revenues or profits are pressured or falling, the debt and interest expense still need to be paid and can become problematic if there isn't enough revenue to meet the obligations.