Leverage

In business a person with leverage is someone who can influence a company’s operations and get things done, usually with only minimal effort. Within a firm there are two kinds of leverage: operating leverage and financial leverage. Operating leverage arises from the use of fixed costs within the firm’s total cost structure. The higher the percentage of fixed COSTS relative to variable costs, the higher the degree of operating leverage for the firm. With high operating leverage, small changes in sales cause larger changes in a firm’s operating INCOME (called earnings before interest and taxes, or EBIT). For example, if a firm has a degree of operating leverage equal to 3, a 1-percent increase (or decrease) in sales results in a 3-percent increase (decrease) in its EBIT. Operating leverage thus magnifies the effects of increases and decreases in sales. Typically firms with high degrees of operating leverage are CAPITAL-intensive with automated production. Such firms have a heavy INVESTMENT in plant and equipment, creating large fixed costs relative to variable costs. Financial leverage arises from the proportion of debt within the firm’s capital structure. The higher the percentage of debt relative to ASSETS (that is, the higher the firm’s debt ratio), the higher the degree of financial leverage. With financial leverage, small changes in EBIT cause larger changes in earnings per share (EPS). For example, if a firm has a degree of financial leverage equal to 2, a 1-percent increase (decrease) in EBIT results in a 2-percent increase (decrease) in EPS. Like operating leverage, financial leverage magnifies the effects of increases and decreases in sales. Typically firms with high degrees of financial leverage are those acquired in LEVERAGED BUYOUTs and those with stable sales, such as PUBLIC UTILITIES. For firms with high degrees of both operating and financial leverage, small changes in sales will lead to volatile fluctuations in its EPS.