Operating Leverage and Financial Leverage.
A company's leverage is divided into two areas, operating leverage and financial leverage. A company's operating leverage is closely tied to its cost structure and its use of fixed and variable costs. Financial leverage is when a company carries both debt and equity financing. Companies with financial leverage are said to be trading on the equity. In other words, a company is using equity capital as a borrowing base in a desire to increase returns. But what are the parameters of operating and financial leverage and why should managers fully understand the pros and cons of these accounting and finance tools? .
Operating Leverage:.
Operating leverage can be examined and defined from the context of accounting and finance. Two similar but different definitions of operating leverage are understood from accounting and from finance. In accounting, operating leverage is a measure of how sensitive net income is to percentage changes to sales. When operating leverage is high, a small percentage increase in sales can produce a much larger change in net income. In finance, operating leverage can be defined as the extent to which fixed costs are used in a company's operations. When operating leverage is high, then a high percentage of the company's total costs are fixed. The accounting version keys in on the end result and the impact on sales and net income from having high/low operating leverage, while the finance version keys in on the origin of operating leverage in relation to the firm's cost structure. .
Many industry factors play a large part in determining a company's operating leverage, however, a company can have some control of its operating leverage by its capital budgeting decisions. A company can make capital budgeting decisions that have lower fixed costs, thus managing some of the company's overall operating leverage (Jardine).
One potential "effect" caused by the presence of operating leverage is that a change in the volume of sales results in a "more than proportional" change in operating profit (or loss).
