Operating leverage and financial leverage are two different metrics used to determine the financial health of a company.
Operating Leverage Versus Financial Leverage: An Overview
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. The break-even point is where the 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.
- 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.
- Operating leverage can help companies determine their break-even point for profitability.
- Financial leverage refers to the amount of debt used to finance the operations of a company.
Operating Leverage and Fixed Costs
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 do not fluctuate regardless of the number of sales generated by a company.
Some examples of fixed costs include:
- interest expense
Operating Leverage and Variable Costs
Variable costs are expenses 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 are variable costs while salaries for the corporate office would be a fixed cost.
Operating leverage can help companies determine what their break-even point is for profitability. In other words, the point where the profit generated from sales covers both the fixed costs as well as the 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 because it must maintain the plant and equipment needed for operations. On the other hand, a consulting company has fewer fixed assets such equipment and would, therefore, have low operating leverage.
Using a higher degree of operating leverage can increase the risk of cash flow problems resulting from errors in forecasts of future sales.
Financial Leverage Explained
Financial leverage is a metric that shows how much a company uses debt to finance its operations. A company with a high level of leverage needs profits and revenue that are high enough to compensate for the additional debt they show on their balance sheet.
Investors look at a company's leverage because it is an indicator of the solvency of the company. Also, debt 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 must still be paid and can become problematic if there is not enough revenue to meet debt and operational obligations.