Question

Discuss the advantages and disadvantages of operating and financial leverage.

Answer 1

Leverage is an investment strategy of using borrowed capital to increase the potential return of an investment.

Operating Leverage:

It is leverage created with the help of fixed expense in the capital structure. Higher the fixed expenses, higher is the OL. OL directly impacts the operating profit.  Under good economic conditions, an increase of 1% in sales will have more than 1% change in operating profits.

High operating leverage means high fixed costs, usually found in a company that relies on expensive equipment and technology to produce its products. A percentage change in revenue is directly reflected in operating profit because the cost of producing revenue remains unchanged.

High operating leverage implies that a firm is making few sales but with high margins. This can pose significant risks if a firm incorrectly forecasts future sales. If a future sales forecast is slightly higher than the actual, this could lead to a huge discrepancy between actual and budgeted cash flow, which will have a significant effect on a firm's future operating ability.

Financial Leverage:

Financial leverage arises when a firm decides to finance the majority of its assets by taking on debt. Firms do this when they are unable to raise enough capital by issuing shares in the market to meet their business needs. If a firm needs capital, it will seek loans, lines of credit, and other financing options.

When a firm takes on debt, that debt becomes a liability on its books, and the company must pay interest on that debt. A company will only take on significant amounts of debt when it believes that return on assets (ROA) will be higher than the interest on the loan.

Financial leverage has two primary advantages:

• Enhanced earnings. Financial leverage may allow an entity to earn a disproportionate amount on its assets.

• Favorable tax treatment. In many tax jurisdictions, interest expense is tax-deductible, which reduces its net cost to the borrower.

However, financial leverage also presents the possibility of disproportionate losses, since the related amount of interest expense may overwhelm the borrower if it does not earn sufficient returns to offset the interest expense. This is a particular problem when interest rates rise or the returns from assets decline.

The unusually large swings in profits caused by a large amount of leverage increase the volatility of a company's stock price. This can be a problem when accounting for stock options issued to employees, since highly volatile stocks are considered to be more valuable, and so create a higher compensation expense than would less volatile shares.