Operating Leverage vs Financial Leverage
Leverage is a term that is very popular in the world of investment and also in corporate circles. It is common knowledge that both investors and management of a company are interested in securing better returns on their investment. Both make use of leverage to see that their investment makes greater profits but this is a situation that does not necessarily result is success for both. In fact, with high leverages, chances of incurring losses are more than when they are not employed. Two main types of leverages used commonly are operating and financial leverage. Not many know real differences between them. This article attempts to highlight these differences.
In a company, there are two types of costs, fixed and variable costs. The ratio of fixed to variable costs in a company reflects the volume of operating leverage used by the company. A high fixed to variable cost ratio simply indicates that the company is employing operating leverage. On the contrary, a higher variable cost to fixed cost ratio indicates smaller operating leverage. Operating leverage is also dependent upon profit margins and the number of sales. A company with high profit margin and few sales is highly leveraged while a company that generates high sales at low profit margins is obviously less leveraged.
On the other hand, financial leverage is talked about when a company decides to get its assets financed by taking loans. This becomes inevitable when raising capital by issuing shares to public is not possible. Now availing loans means they become a liability on which it is necessary for the company to pay interest. Here it is to be remembered that a company takes loans only when it is of the opinion that return on investment from such loans will be higher than the interest it needs to pay on the loan amount.
If you are an investor, you need to pay attention to both these factors. If after going through its financial statements, you find that both operating as well as financial leverage are high, it is better to stay away from such a company. High financial leverage can be a big problem when the calculations of the company go awry and the return on investments are not as high as company has planned and they fall below the rate of interest that it needs to pay to its creditors.
What is the difference between Operating Leverage and Financial Leverage?
While financial leverage is more important in the case of huge business houses, it is operating leverage that is crucial for small business units. Fixed cost of production is more important for small companies while it is not so important for large production houses. It is financial leverage that makes all the difference in the debt equity ratio of a big company. The combined effect of both the leverages is given by the following formula.
Degree of combined leverage = Degree of operating leverage X degree of operating leverage