Operating Leverage vs Financial leverage

Operating Leverage vs Financial leverage (Differences)

Operating Leverage vs. Financial Leverage – Leverage is a firm’s ability to employ new assets or funds to create better returns or to reduce costs. That’s why leverage for any company is very significant.

There are two kinds of leverage – operating leverageOperating LeverageOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.read more and financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more. When we combine the two, we get a third type of leverage – combined leverage. Since both of these (operating leverage and financial leverage) are quite different in nature, and we look at different metrics to calculate them, we need to discuss it in detail to understand them better.

Operating-Leverage-vs-Financial-leverage

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Source: Operating Leverage vs Financial leverage (wallstreetmojo.com)

  • Operating leverage can be defined as a firm’s ability to use fixed costs (or expenses) to generate better returns for the firm.
  • Financial leverage can be defined as a firm’s ability to increase better returns and to reduce the cost of the firm by paying lesser taxes.

Operating leverage, on the one hand, compares how well a firm uses its fixed costs and financial leverage, on the other hand, looks at various capital structures and chooses the one which reduces taxes most.

In this article, we at the comparative analysis of operating leverage vs. financial leverage.

Without any ado, let’s get started with the head to head differences between operating leverage and financial leverage in an infographics

Operating Leverage vs. Financial leverage Infographics

Let’s look at the top differences between operating leverage and financial leverage below –

Operating-Leverage-vs-Financial-leverage

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Source: Operating Leverage vs Financial leverage (wallstreetmojo.com)

Operating Leverage vs. Financial leverage (Comparison Table)

Basis for Comparison between Financial Leverage vs. Operating LeverageOperating LeverageFinancial Leverage
1.    MeaningOperating leverage can be defined as a firm’s ability to use fixed costs to generate more returns.Financial leverage can be defined as a firm’s ability to use capital structure to earn better returns and to reduce taxes.
2.    What it’s all about?It’s about the fixed costs of the firmFixed Costs Of The FirmFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more.It’s about the capital structure of the firm.
3.    MeasurementOperating leverage measures the operating risk of a business.Financial leverage measures the financial risk of a business.
4.    CalculationOperating leverage can be calculated when we divide contribution by EBIT of the firm.Financial leverage can be calculated when we divide EBIT by EBTEBTPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more of the firm.
5.    ImpactWhen the degree of operating leverage is higher, it depicts more operating risk for the firm and vice versa.When the degree of financial leverageDegree Of Financial LeverageThe degree of financial leverage formula computes the change in net income caused by a change in the company's earnings before interest and taxes. It aids in determining how sensitive the company's profit is to changes in capital structure.read more is higher, it depicts more financial risk for the firm and vice versa.
6.    In relation withThe degree of operating leverage is usually higher than Break Even PointBreak Even PointBreak-even analysis refers to the identifying of the point where the revenue of the company starts exceeding its total cost i.e., the point when the project or company under consideration will start generating the profits by the way of studying the relationship between the revenue of the company, its fixed cost, and the variable cost.read more.Financial leverage has a direct relationship with the liability side of the balance sheet.
7.    How much is it preferred?The preference is lower.The preference is much higher.

Conclusion

Operating leverage and financial leverage are both critical in their own terms. And they both help businesses in generating better returns and reduce costs. So the question remains can a firm use both of these leverages? The answer is yes.

If a company can use its fixed costs well, they would be able to generate better returns just by using operating leverage. And at the same time, they can use financial leverage by changing their capital structure from total equity to 50-50, 60-40, or 70-30 equity-debt proportion. Even if changing the capital structure would prompt the company to pay interests; still, they would be able to generate a better rate of returns and would be able to reduce the amount of taxes at the same time.

That’s why using operating leverage and financial leverage is a great way to improve the rate of returns of the company and to reduce the costs during a particular period.

This article has been a guide to the top differences between Operating Leverage vs. Financial Leverage. Here we also discuss the Operating Leverage and Financial Leverage differences with examples, infographics, and comparison tables. You may also have a look at the following articles for gaining further knowledge in corporate finance –