Leverage is a term that describes the use of borrowed funds or fixed costs to increase the potential returns or risks of a firm. Leverage can be classified into two types: operating leverage and financial leverage. Operating leverage refers to the use of fixed operating costs, such as depreciation and rent, to magnify the effects of changes in sales on the firm’s operating income. Financial leverage refers to the use of debt or other fixed financial charges, such as interest and dividends, to magnify the effects of changes in operating income on the firm’s net income or earnings per share.

Leverage analysis is a technique that helps to measure the degree of operating leverage and financial leverage of a firm, and how they affect the firm’s profitability, solvency, and risk. Leverage analysis can also help to compare the performance of different firms or industries, and to evaluate the optimal capital structure or mix of debt and equity for a firm.

In this blog post, we will explain how to calculate and interpret the leverage ratios, and how to use them for financial decision making.

Operating Leverage

Operating leverage is the ratio of fixed operating costs to total operating costs. It measures the sensitivity of the firm’s operating income to changes in sales. A high operating leverage means that the firm has a high proportion of fixed operating costs, and a small change in sales will result in a large change in operating income. A low operating leverage means that the firm has a low proportion of fixed operating costs, and a large change in sales will result in a small change in operating income.

The degree of operating leverage (DOL) can be calculated as follows:

DOL=Percentage change in salesPercentage change in operating income​=Operating incomeContribution margin​

where contribution margin is the difference between sales and variable operating costs, and operating income is the difference between contribution margin and fixed operating costs.

The DOL can also be calculated at a given level of sales as follows:

DOL=Q(P−V)−FQ(P−V)​

where Q is the quantity of output sold, P is the price per unit, V is the variable operating cost per unit, and F is the total fixed operating cost.

The DOL indicates the percentage change in operating income for a given percentage change in sales. For example, if the DOL is 3, it means that a 10% increase in sales will result in a 30% increase in operating income, and vice versa.

The DOL can be used to assess the operating risk of a firm, which is the risk of not being able to cover the fixed operating costs. A high DOL implies a high operating risk, as the firm’s operating income will fluctuate widely with sales. A low DOL implies a low operating risk, as the firm’s operating income will be more stable with sales.

The DOL can also be used to evaluate the operating efficiency of a firm, which is the ability to generate operating income from sales. A high DOL implies a high operating efficiency, as the firm can leverage its fixed operating costs to generate more operating income from sales. A low DOL implies a low operating efficiency, as the firm cannot leverage its fixed operating costs to generate more operating income from sales.

Financial Leverage

Financial leverage is the ratio of debt to equity. It measures the extent to which the firm uses borrowed funds to finance its assets. A high financial leverage means that the firm has a high proportion of debt, and a small change in operating income will result in a large change in net income or earnings per share. A low financial leverage means that the firm has a low proportion of debt, and a large change in operating income will result in a small change in net income or earnings per share.

The degree of financial leverage (DFL) can be calculated as follows:

DFL=Percentage change in operating incomePercentage change in net income​=Operating income – InterestOperating income​

where net income is the difference between operating income and interest, and interest is the total interest expense on debt.

The DFL can also be calculated at a given level of operating income as follows:

DFL=E−IE​

where E is the operating income, and I is the interest.

The DFL indicates the percentage change in net income for a given percentage change in operating income. For example, if the DFL is 2, it means that a 10% increase in operating income will result in a 20% increase in net income, and vice versa.

The DFL can be used to assess the financial risk of a firm, which is the risk of not being able to meet the fixed financial obligations. A high DFL implies a high financial risk, as the firm’s net income will fluctuate widely with operating income. A low DFL implies a low financial risk, as the firm’s net income will be more stable with operating income.

The DFL can also be used to evaluate the financial benefit of a firm, which is the ability to increase the return on equity by using debt. A high DFL implies a high financial benefit, as the firm can leverage its debt to generate more net income or earnings per share from operating income. A low DFL implies a low financial benefit, as the firm cannot leverage its debt to generate more net income or earnings per share from operating income.

Combined Leverage

Combined leverage is the product of operating leverage and financial leverage. It measures the overall effect of leverage on the firm’s earnings per share. A high combined leverage means that the firm has a high degree of both operating and financial leverage, and a small change in sales will result in a large change in earnings per share. A low combined leverage means that the firm has a low degree of both operating and financial leverage, and a large change in sales will result in a small change in earnings per share.

The degree of combined leverage (DCL) can be calculated as follows:

DCL=Percentage change in salesPercentage change in earnings per share​=SalesEarnings per share​×Operating incomeSales​×Net incomeOperating income​×Earnings per shareNet income​=DOL×DFL

where earnings per share is the net income divided by the number of shares outstanding.

The DCL indicates the percentage change in earnings per share for a given percentage change in sales. For example, if the DCL is 6, it means that a 10% increase in sales will result in a 60% increase in earnings per share, and vice versa.

The DCL can be used to assess the total risk of a firm, which is the combined effect of operating and financial risk. A high DCL implies a high total risk, as the firm’s earnings per share will fluctuate widely with sales. A low DCL implies a low total risk, as the firm’s earnings per share will be more stable with sales.

The DCL can also be used to evaluate the total benefit of a firm, which is the combined effect of operating and financial efficiency and benefit. A high DCL implies a high total benefit, as the firm can leverage its fixed operating costs and debt to generate more earnings per share from sales. A low DCL implies a low total benefit, as the firm cannot leverage its fixed operating costs and debt to generate more earnings per share from sales.

Example

Let us consider an example of a firm that has the following data:

| Sales | 1000 | | Variable operating cost | 400 | | Fixed operating cost | 200 | | Interest | 100 | | Tax rate | 30% | | Number of shares | 100 |

We can calculate the operating income, net income, and earnings per share as follows:

| Operating income | 400 | | Net income | 210 | | Earnings per share | 2.1 |

We can also calculate the DOL, DFL, and DCL as follows:

| DOL | 2.5 | | DFL | 1.9 | | DCL | 4.75 |

We can interpret the results as follows:

• The firm has a high operating leverage, as a 10% increase in sales will result in a 25% increase in operating income, and vice versa.
• The firm has a high financial leverage, as a 10% increase in operating income will result in a 19% increase in net income, and vice versa.
• The firm has a high combined leverage, as a 10% increase in sales will result in a 47.5% increase in earnings per share, and vice versa.
• The firm has a high operating risk, as its operating income will fluctuate widely with sales.
• The firm has a high financial risk, as its net income will fluctuate widely with operating income.
• The firm has a high total risk, as its earnings per share will fluctuate widely with sales.
• The firm has a high operating efficiency, as it can leverage its fixed operating costs to generate more operating income from sales.
• The firm has a high financial benefit, as it can leverage its debt to generate more net income or earnings per share from operating income.
• The firm has a high total benefit, as it can leverage its fixed operating costs and debt to generate more earnings per share from sales.