What is the Difference Between Operating Leverage and Financial Leverage?

Operating leverage and financial leverage are two different metrics used to determine a company's financial risk and return. Here are the key differences between them:

Operating Leverage:

1. Operating leverage measures the extent to which a company's costs are structured, and it is used to determine the company's breakeven point, which is when revenue from sales covers both fixed and variable costs of production.
2. It is an indication of how a company uses fixed costs to generate returns.
3. High operating leverage can lead to higher business risk, as it may increase the risk of cash flow problems resulting from fluctuations in sales.
4. Low operating leverage is generally preferred, as it leads to lower business risk and more stable profits.

Financial Leverage:

1. Financial leverage refers to the amount of debt used to finance the operations of a company.
2. It measures the effect of interest expenses on the company's profits and capital structure.
3. Financial leverage can lead to higher profitability, but it also increases the company's risk and potential for bankruptcy if the company cannot service its debt.
4. A higher degree of financial leverage is generally associated with higher business risk and potential for bankruptcy, while a lower degree of financial leverage is considered safer.

In summary, operating leverage focuses on the company's cost structure and its ability to generate returns using fixed costs, while financial leverage is concerned with the company's capital structure and its ability to raise funds through debt. Both leverage types can impact a company's risk and return, and it is essential for management to balance the two to achieve an optimal level of leverage.

Comparative Table: Operating Leverage vs Financial Leverage

Here is a table comparing the differences between operating leverage and financial leverage:

• Operating leverage measures the effect of fixed operating costs, while financial leverage measures the effect of interest expenses.
• Operating leverage influences sales and EBIT, while financial leverage affects EBIT and EPS.
• Operating leverage arises due to the company's cost structure, whereas the capital structure of the company is responsible for financial leverage.
• Low operating leverage is preferred because higher DOL will cause high BEP (breakeven point) and low profits. On the other hand, high financial leverage is suitable when the ROCE (return on capital employed) is higher.