Operating leverage and financial leverage both magnify the changes that occur to earnings due to fixed costs in a company’s capital structures. Operating leverage magnifies changes in earnings before interest and taxes (EBIT) as a response to changes in sales when a company’s operational costs are relatively fixed. Financial leverage magnifies how earnings per share (EPS) change as a response to changes in EBIT where the fixed cost is that of financing, specifically interest 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 not altered by an increase or decrease in the total number of goods or services a company produces. Variable costs are those that vary in direct relationship to a company’s production — variable costs rise when production increases and fall when production decreases. Businesses with higher ratios of fixed costs to variable costs are characterized as using more operating leverage, while businesses with lower ratios of fixed costs to variable costs use less operating leverage. Utilizing a higher degree of operating leverage increases the risk of cash flow problems resulting from errors in forecasts of future sales.
The degree of financial leverage (DFL) measures a percentage change of earnings per share for each unit’s change in EBIT that result from a company’s changes in its capital structure. Earnings per share become more volatile when the DFL is higher. Financial leverage magnifies earnings per share and returns because interest is a fixed cost. When a company’s revenues and profits are on the rise, this leverage works very favorably for the company and for investors. However, when revenues or profits are pressured or falling, the exponential effects of leverage can become problematic.