Operating leverage measures the use of assets acquired with a fixed cost to increase returns. A firm with a high operating leverage has got more operating fixed costs than variable costs. In operating leverage, change in sales volume results in a greater change in operating profits or losses. High operating leverage gives a rise to increased risk in business.
Financial leverage relates the use of interest accruing debt financing in its capital structure to increase revenue and particularly earnings per share. A firm with a high financial leverage has got more interest accruing debt than dividend accruing capital. A high financial leverage will necessitate increased risks in financing.
Calculating Operating Leverage And Financial Leverage
Operating leverage = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
It is also arrived at by dividing contribution by operating profit. Operating leverage measures the proportion of change in income caused by a proportionate change in sales. Risk in operating leverage is known as operating risk and its bearing is on the inability to cover for the firms’ fixed operating costs. A break even analysis allows us to examine some of the critical profit drivers which influence the operating leverage like relationship between sales volume with cost and profits. Fixed costs are recovered at breakeven and any extra sales above breakeven will increase profits.
Financial leverage = earnings before interest and tax(EBIT) / (EBIT – interest expense) – preference dividend/ (1- tax rate)
The inability to cover fixed financial costs results in a financial risk in financial leverage.