Difference between Operating Leverage and Financial Leverage

Difference between Operating Leverage and Financial Leverage: The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase the return to its shareholders.

Operating Leverage

The leverage associated with investment activities is called as operating leverage. It is caused due to fixed operating expenses in the company. Operating leverage may be defined as the company’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage consists of two important costs viz., fixed cost and variable cost. When the company is said to have a high degree of operating leverage if it employs a great amount of fixed cost and smaller amount of variable cost. Thus, the degree of operating leverage depends upon the amount of various cost structure. Operating leverage can be determined with the help of a break even analysis.

Operating leverage can be calculated with the help of the following

Operating Leverage = Contribution / Operating Profit (EBIT)

Degree of Operating Leverage

The degree of operating leverage may be defined as percentage change in the operating income (EBIT) resulting from a percentage change in the sales. It can be calculated with the help of the following formula:

DOL = Percentage change in EBIT / Percentage change in sale

Financial leverage

A leverage activity with financing activities is called financial leverage. Financial leverage represents the relationship between the company’s earnings before interest and taxes (EBIT) or operating profit and the earning available to equity shareholders.

Financial leverage is defined as “the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share”. It involves the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. “The use of long-term fixed interest bearing debt and preference share capital along with share capital is called financial leverage or trading on equity”.

Financial leverage may be favourable or unfavourable depends upon the use of fixed cost funds.

Favourable financial leverage occurs when the company earns more on the assets purchased with the funds, then the fixed cost of their use. Hence, it is also called as positive financial leverage

Unfavourable financial leverage occurs when the company does not earn as much as the funds cost. Hence, it is also called as negative financial leverage.

Financial leverage can be calculated with the help of the following formula:

Financial Leverage = Operating Profit (EBIT) / Profit Before Tax

Difference between Operating Leverage and Financial Leverage

Operating LeverageFinancial Leverage
Operating leverage is associated with investment activities of the companyFinancial leverage is associated with financing activities of the company.
Operating leverage consists of fixed operating expenses of the company.Financial leverage consists of Fixed Financial Expenses of the company
It represents the ability to use fixed operating cost.It represents the ability to use fixed financial cost.
Operating leverage can be calculated by=Contribution/EBITFinancial leverage can be calculated by=EBIT/EBT
A percentage change in the profits resulting from a percentage change in the sales is called as degree of operating leverage.A percentage change in taxable profit is the result of percentage change in EBIT.
Trading on equity is not possible by using operating leverageTrading on equity is possible only when the company uses financial leverage.
Operating leverage depends upon fixed cost and variable cost.Financial leverage depends upon the operating profits & fixed financial costs.
Tax rate and interest rate will not affect the operating leverage.Financial leverage will change due to tax rate and interest rate.

Uses of Financial Leverage

Financial leverage helps to examine the relationship between EBIT and EPS. Financial leverage measures the percentage of change in taxable income to the percentage change in EBIT. It locates the correct profitable financial decision regarding capital structure of the company. It is one of the important devices which is used to measure the fixed cost proportion with the total capital of the company. If the firm acquires fixed cost funds at a higher cost, then the earnings from those assets, the earning per share and return on equity capital will decrease. The impact of financial leverage can be understood with the help of the following exercise.

Uses of Operating Leverage

Operating leverage is one of the techniques to measure the impact of changes in sales which lead for change in the profits of the company. If any change in the sales, it will lead to corresponding changes in profit. Operating leverage helps to identify the position of fixed cost and variable cost.

Operating leverage measures the relationship between the sales and revenue of the company during a particular period. Operating leverage helps to understand the level of fixed cost which is invested in the operating expenses of business activities. It describes the overall position of the fixed operating cost.

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