10.3 Financial and Operating Leverage

Financial and operating leverage are key concepts in capital structure. They can boost returns but also increase risk. Financial leverage uses debt to finance assets, while operating leverage relies on fixed costs in operations.

Both types of leverage can amplify gains and losses. Financial leverage increases potential return on equity but also financial risk. Operating leverage can boost profitability but raises business risk. Companies must balance these risks against potential rewards.

Financial Leverage and Operating Leverage

Definition and Key Differences

Top images from around the web for Definition and Key Differences

• 

  Thinking About Financial Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Financial Ratios – Financial Management for Small Businesses: Financial Statements & Present ... View original

  Is this image relevant?

• 

  Thinking About Operating Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Thinking About Financial Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Financial Ratios – Financial Management for Small Businesses: Financial Statements & Present ... View original

  Is this image relevant?

1 of 3

Top images from around the web for Definition and Key Differences

• 

  Thinking About Financial Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Financial Ratios – Financial Management for Small Businesses: Financial Statements & Present ... View original

  Is this image relevant?

• 

  Thinking About Operating Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Thinking About Financial Leverage | Boundless Finance View original

  Is this image relevant?

• 

  Financial Ratios – Financial Management for Small Businesses: Financial Statements & Present ... View original

  Is this image relevant?

1 of 3

• Financial leverage involves using debt to finance assets and operations, aiming to increase returns to shareholders
  • It is the extent to which a company uses fixed-income securities (debt and preferred equity) to magnify returns to common shareholders
• Operating leverage is the degree to which a firm or project relies on fixed costs in its cost structure
  • It measures how revenue growth translates into growth in operating income
• The main difference between financial and operating leverage:
  • Financial leverage refers to the use of debt
  • Operating leverage refers to the use of fixed costs in the cost structure
• Both types of leverage can amplify returns but also increase risk
  • Financial leverage increases financial risk
  • Operating leverage increases business risk

Impact on Risk and Return

• Financial and operating leverage can significantly affect a firm's risk and return profile
  • They can magnify gains when things are going well but also magnify losses when things are going poorly
• Financial leverage increases potential return on equity by allowing a company to earn a return on assets it doesn't own
  • However, it also increases financial risk because interest payments must be made regardless of operating performance
• Operating leverage can increase profitability as fixed costs don't grow with sales
  • However, it also increases business risk because fixed costs must be covered regardless of sales volume
• The combined effect of financial and operating leverage is called total leverage
  • Companies with high total leverage are considered very risky

Calculating Leverage Degrees

Degree of Financial Leverage (DFL)

• DFL measures the percentage change in earnings per share (EPS) resulting from a given percentage change in earnings before interest and taxes (EBIT)
  • Calculated as: $DFL = \frac{\% \text{ change in EPS}}{\% \text{ change in EBIT}}$
• A higher DFL indicates a higher level of leverage and, therefore, higher risk
  • Example: A DFL of 2 means a 10% change in EBIT will result in a 20% change in EPS

Degree of Operating Leverage (DOL)

• DOL measures the percentage change in operating income resulting from a given percentage change in sales
  • Calculated as: $DOL = \frac{\% \text{ change in operating income}}{\% \text{ change in sales}}$
• DOL is a function of the company's cost structure
  • Companies with high fixed costs will have a higher DOL than companies with low fixed costs

Leverage's Impact on Risk and Return

Magnification of Gains and Losses

• Financial and operating leverage can significantly impact a firm's risk and return profile
  • They magnify gains when things are going well but also magnify losses when things are going poorly
• The combined effect of financial and operating leverage is called total leverage
  • Companies with high total leverage are considered very risky

Financial Leverage's Impact

• Financial leverage increases potential return on equity by allowing a company to earn a return on assets it doesn't own
  • This is known as the leveraging effect
• However, it also increases financial risk because interest payments must be made regardless of operating performance

Operating Leverage's Impact

• Operating leverage can increase profitability as fixed costs don't grow with sales
• However, it also increases business risk because fixed costs must be covered regardless of sales volume
  • This is known as the operating risk effect
• Operating leverage increases the company's breakeven point, making it more vulnerable to sales downturns

Financial vs Operating Risk Trade-off

Balancing Risk and Return

• Financial risk and operating risk are two different but related forms of risk that companies must manage
  • The optimal balance depends on the company's industry, competitive position, and stage in the business cycle
• Increasing financial leverage increases financial risk but can also increase returns if the company earns a higher return on borrowed funds than it pays in interest
• Increasing operating leverage can boost operating profits but also increases the breakeven point and vulnerability to sales downturns

Factors Influencing Leverage Decisions

• Companies with stable, predictable cash flows can safely take on more financial leverage than companies with volatile cash flows
  • Example: Utility companies often have high financial leverage due to their stable cash flows
• Companies in industries with high entry barriers and stable demand can safely operate with higher operating leverage
  • Example: Airlines often have high operating leverage due to their high fixed costs (planes, terminals)
• The optimal leveraging decision balances the potential benefits of leverage (higher returns) against the potential costs (higher risk)
  • This balance is different for every company and can change over time as circumstances change