Punjabi University Patiala

MBA-1 (semester-2)

Session- 2021-2023

Topic- Leverage

Submitted to- Dr Parneet Kaur

Submitted By- Samarth Garg

Roll no- 21421207

Section- D
Operating leverage and financial leverage are two different metrics used to determine the financial
health of a company.

Operating leverage is an indication of how a company's costs are structured. The metric is used to
determine a company's breakeven point, which is when revenue from sales covers both the fixed and
variable costs of production. Financial leverage refers to the amount of debt used to finance the
operations of a company.

Operating leverage and financial leverage both tell you different things about a company's financial
health.

Operating leverage is an indication of how a company's costs are structured and also is used to
determine its breakeven point.

Financial leverage refers to the amount of debt used to finance the operations of a company.

Operating Leverage and Fixed Costs

Operating leverage measures the extent to which a company or specific project requires some aggregate
of both fixed and variable costs. Fixed costs are those costs or expenses that do not fluctuate regardless
of the number of sales generated by a company. Some examples of fixed costs include:

salaries

rent

utilities

interest expense

depreciation

Operating Leverage and Variable Costs

Variable costs are expenses that vary in direct relationship to a company’s production. Variable costs
rise when production increases and fall when production decreases. For example, inventory and raw
materials are variable costs while salaries for the corporate office would be a fixed cost.
Operating leverage can help companies determine what their breakeven point is for profitability. In
other words, the point where the profit generated from sales covers both the fixed costs as well as the
variable costs.

A manufacturing company might have high operating leverage because it must maintain the plant and
equipment needed for operations. On the other hand, a consulting company has fewer fixed assets such
as equipment and would, therefore, have low operating leverage.

Using a higher degree of operating leverage can increase the risk of cash flow problems resulting from
errors in forecasts of future sales.

Financial Leverage Explained

Financial leverage is a metric that shows how much a company uses debt to finance its operations. A
company with a high level of leverage needs profits and revenue that are high enough to compensate
for the additional debt it shows on its balance sheet.

Investors look at a company's leverage because it is an indicator of the solvency of the company. Also,
debt can help magnify earnings and earnings per share. However, there is a cost associated with
leverage in the form of interest expense.

When a company's revenues and profits are on the rise, leverage works well for a company and
investors. However, when revenues or profits are pressured or falling, the debt and interest expense
must still be paid and can become problematic if there is not enough revenue to meet debt and
operational obligations.

Financial Leverage

When a company uses debt financing, its financial leverage increases. More capital is available to boost
returns, at the cost of interest payments, which affect net earnings.

Example 1

Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to make a 10%
down payment and take a $450,000 mortgage for the rest of the payment (mortgage cost is 5%
annually). Jim wants to purchase the house for $500,000 cash today. Who will realize a higher return on
investment if they sell the house for $550,000 a year from today.

Although Jim makes a higher profit, Bob sees a much higher return on investment because he made
$27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with a $500,000
investment).

Example 2

Using the same example above, Bob and Jim realize they can only sell the house for $400,000 after a
year. Who will see a greater loss on their investment.

Now that the value of the house decreased, Bob will see a much higher percentage loss on his
investment (-245%), and a higher absolute dollar amount loss because of the cost of financing. In this
instance, leverage has resulted in an increased loss.

Operating Leverage Formula

The operating leverage formula measures the proportion of fixed costs per unit of variable or total cost.
When comparing different companies, the same formula should be used.

Operating Leverage Formula

Example

Company A and company B both manufacture soda pop in glass bottles. Company A produced 30,000
bottles, which cost them $2 each. Company B produced 45,000 bottles at a price of $2.50 each.
Company A pays $20,000 in rent, and company B pays $35,000. Both companies pay an annual rent,
which is their only fixed expense. Compute the operating leverage of each company using both methods.

Operating Leverage Formula - Example

Step 1: Compute the total variable cost

Company A: $2/bottle * 30,000 bottles = $60,000

Company B: $2.50/bottle * 45,000 bottles = $112,500

Step 2: Find the fixed costs

In our example, the fixed costs are the rent expenses for each company.

Company A: $20,000

Company B: $35,000

Step 3: Compute the total costs

Company A: Total variable cost + Total fixed cost = $60,000 + $20,000 = $80,000

Company B: Total variable cost + Total fixed cost = $112,500 + $35,000 = $147,500

Step 4: Compute the operating leverages

Method 1:

Operating Leverage = Fixed costs / Variable costs

Company A: $20,000 / $60,000 = 0.333x

Company B: $35,000 / $112,500 = 0.311x