Leverage is a measure of using given resources in such a way that the potential positive or negative outcome is magnified. (“Leverage (finance)” 2008). In a firm, this leverage is broken into operating and financial leverage.
Operating leverage measures the degree upon which fixed costs is used in a company’s production processes. A higher operating leverage means that a company would be more sensitive to change in sales, since it must pay its fixed costs whatever the amount of revenue it has. Consequently, it would benefit from a lower debt ratio because of this higher business risk. The degree of operating leverage is measured as a the quotient of the percentage change in EBIT and the percentage change in sales..
Financial leverage refers to a company’s use of fixed charge securities like debt and preferred stock to increase the return on common stockholders. The degree of financial leverage is measured as the change in EBIT over the change in earnings after interest. With the optimum mix of debt and equity a company can maximize its EPS, but higher debt carries higher risk. Risk is passed on to common stockholders, but a firm that borrows will improve its return on equity.
Both are measures of change in one variable on another variable (“Leverage (finance)” 2008). Their difference lies in the fixed expenses that are behind them—in operating leverage it is the fixed costs of production like depreciation, while financial leverage depends on finance costs like interest expense. However, both are interrelated in management decisions. A reduction in operating leverage would normally lead to an increase in the optimum amount of financial leverage, with the inverse being true.
R E F E R E N C E
“Leverage (finance)”. (2008). Wikipedia: The Free Encyclopedia. Retrieved April 29,
2008 from http://en.wikipedia.org/wiki/Leverage_%28finance%29