Question

What is the difference between operating and financial leverage? What are risks of having an excessive amount of financial leverage in an organization? What is the degree of total leverage?

Answer 1

Operating leverage is about the extent to which firm can increase its operating income by increasing its revenue. If a business has high gross margin and low variable costs, it will have higher operating leverage. It is the ratio between percentage change in operating income to percentage change in total sales.

Financial leverage studies the impact of having fixed income securities like debt and preference and debt in capital structure to increase earnings. It is the ratio between percentage change in EPS to percentage change in EBIT.

If financial leverage is too high in an organization it increases risk of default. Potential investors may be not interested in a company having too much debt in capital.Because if financial leverage is high, if there is a default then losses will also be magnified due to leverage effect of interest.

Total leverage is a measure of change in company's EPS due to a change in EBIT. It is obviously a combination of both operating and financial leverage.