Financial and operating leverage are two common concepts used in finance and accounting. Although these terms may sound similar, they have different meanings and implications for businesses. In this article, we will discuss the difference between financial leverage and operating leverage and how they affect a company’s financial performance.

What is Financial Leverage?

Financial leverage refers to the use of debt to finance a company’s operations or investments. It is the degree to which a company uses borrowed funds to finance its operations. The use of debt allows a company to increase its assets, which can lead to higher returns on equity, but it also increases the risk of bankruptcy in case the company fails to meet its debt obligations.

The financial leverage ratio is used to measure the amount of debt that a company uses relative to its equity. It is calculated by dividing total debt by total equity. The higher the ratio, the more leveraged a company is, and the more sensitive it is to changes in interest rates and other economic conditions.

What is Operating Leverage?

Operating leverage, on the other hand, refers to the degree to which a company uses fixed costs in its operations. Fixed costs are those that do not vary with changes in the level of production or sales. Examples of fixed costs include rent, salaries, and equipment maintenance.

The use of fixed costs can help a company reduce its variable costs, which can lead to higher profits. However, it also increases the risk of losses if sales fall below the breakeven point, which is the level of sales at which a company covers all of its costs.

The operating leverage ratio is used to measure the amount of fixed costs that a company uses relative to its variable costs. It is calculated by dividing total fixed costs by total variable costs. The higher the ratio, the more leveraged a company is, and the more sensitive it is to changes in sales volume.

Difference between Financial Leverage and Operating Leverage

The main difference between financial leverage and operating leverage is that financial leverage involves the use of debt to finance a company’s operations, while operating leverage involves the use of fixed costs in a company’s operations.

Financial leverage increases a company’s return on equity by allowing it to use borrowed funds to finance its operations. However, it also increases the risk of bankruptcy in case the company fails to meet its debt obligations. Operating leverage, on the other hand, increases a company’s profit margins by reducing variable costs but also increases the risk of losses if sales fall below the breakeven point.

Another difference between financial leverage and operating leverage is the way they affect a company’s earnings per share (EPS). Financial leverage can increase EPS by boosting returns on equity, while operating leverage can increase EPS by reducing variable costs. However, both types of leverage can also decrease EPS if sales or profits fall below certain levels.

Conclusion

Financial leverage and operating leverage are two important concepts in finance and accounting that can have significant effects on a company’s financial performance. While financial leverage involves the use of debt to finance a company’s operations, operating leverage involves the use of fixed costs in a company’s operations. Both types of leverage can increase a company’s profits, but they also increase the risk of losses if economic conditions change. Understanding the differences between financial leverage and operating leverage is essential for making informed investment decisions.