Financial and Operating leverage - NET exam

                 Financial and Operating leverage

What is leverage?

Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also increases the company's returns; specifically its return on equity.

Financial Leverage 

Financial leverage refers to the amount of debt in the capital structure of the business firm.Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity.he financial leverage formula is measured as the ratio of total debt to total assets. As the proportion of debt to assets increases, so too does the amount of financial leverage. Financial leverage is favorable when the uses to which debt can be put generate returns greater than the interest expense associated with the debt. Many companies use financial leverage rather than acquiring more equity capital, which could reduce the earnings per share of existing shareholders.

financial leverage also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.n short, financial leverage can earn outsized returns for shareholders, but also presents the risk of outright bankruptcy if cash flows fall below expectations.

   Operating leverage

Operating leverage is the degree to which fixed costs exist in a company's cost structure. Generally speaking, operating leverage is fixed costs divided by total costs. Operating leverage is important to the investment community because it is an indicator of the quality of earnings of a firm.It is used to evaluate the break even point of a business, as well as the likely profit levels on individual sales 

•          High operating leverage. A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.
•            Low operating leverage. A large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales. 

Difference between Operating Leverage and Financial Leverage

 

i. Operating leverage is concerned with investment activities of the firm.whereas,Financial leverage is concerned with financing activities of the firm.
ii. It is determined by the cost structure of the firm.whereas,It is determined by the capital structure of the firm
iii. It is the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.whereas,It is the firm’s ability to use fixed financial charges to magnify the effects of changes in EBIT on its earnings per share
iv. The higher the proportion of fixed operating costs to the total operating costs in the cost structure of a firm, the higher is the degree of operating leverage.whereas ,The higher the proportion of fixed charges bearing capital to total financial changes in the capital structure of a firm, the higher is the degrees of financial leverage.
v. Degree of operating leverage enables us to measure the business risk associated with the firm.whereas,
Degree of financial leverage enables us to measure the degree of financial risk, associated with the firm.

The formulae for calculating the operating leverage and financial leverage are:

Operating leverage

                                 % change in PBIT

                             = ---------------------

                                 % change in sales

                          

Financial leverage

                                 % change in PBT

                             = ---------------------

                                 % change in PBIT

Given below, the operating and financial leverages can be calculated directly from the data in one income statement.

                                     Contribution

Operating leverage = ----------------

                                        PBIT

           

                                       PBIT

Financial Leverage = ----------

                                        PBT

Combined leverage factor:

If a firm uses a considerable amount of both operating and financial leverage, even small changes in the level of sales will produce wide fluctuations in PBT. The effect of the superimposition of financial leverage on operating leverage is obtained by multiplying the two leverages. The product is called the combined leverage factor or the leverage multiplier.

Combined leverage factor   = Operating leverage * Financial leverage

                                                    Contribution             PBIT

                                               =  ----------------   *    --------

                                                         PBIT                      PBT

                                                     Contribution

                                               =  ----------------

                                                        PBT