Question

What is the general relationship among operating leverage, financial leverage, and the total leverage of the firm? Do these types of leverage complement one another? Why or why not?

Answer 1

Answer:-

Operating leverage measures the operating risk of the business and financial leverage measures the financial risk of the company.

Operating leverage indicates how company costs are utilized and when the company can reach the break even ie. the sales or the products that are required to manufacture to just have no profit or no loss whereas the Financial leverage is the amount of debt that the company has raised to finance the operations of the company.

Operating costs is used as a measure the fixed operating costs where as the Financial leverage is a measure of the interest incurred (interest expenses) for the capital that has been raised to operate the company.

Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage change in sales
  

Degree of Financial Leverage (DFL) = Percentage change in EPS / Percentage change in EBIT

Degree of Total Leverage (DTL) = DOL x DFL
DTL = (% change in EBIT / % change in sales) x (% change in EPS / % change in EBIT)  
DTL = % change in EPS / % change in sales
These leverages complement each other because finances are used to run the operations of the company and the operating leverage measures the operating risk which in turn is financed through the funds raised which is proportionally related to the financial leverage of the company. Thus they complement each other and are interrelated and non separable.