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What Is the Connection between Operating and Financial Leverage?

Operating and financial leverage are crucial concepts in business, intertwining to magnify a company's potential profits or losses. Operating leverage reflects fixed costs' impact on earnings, while financial leverage involves using debt to finance operations. Their interplay can significantly influence a firm's risk and return profile. How might these levers affect your investments? Let's examine their intricate relationship further.
Geri Terzo
Geri Terzo

A primary connection between operating and financial leverage is an expression of risk. When a company takes on financial leverage, the business is obtaining debt in an attempt to create more attractive returns. There is another way to measure leverage, and it examines sales or revenue growth in relation to income from operations, a comparison known as operating leverage. Operating leverage and financial leverage both seek to enhance financial results. On the flip side, however, any type of leverage could make damages worse in the event of unavoidable losses.

The amount of debt that a business has in relation to equity is a representation of financial leverage. In terms of a financial equation, debt divided by equity leads to the level of leverage that exists. The greater amount of debt that a business takes on, the more financial leverage that entity has entered into.

Man climbing a rope
Man climbing a rope

Financial leverage can be accessed in transactions that occur in the financial markets and can be applied to trading. This activity is typically limited to professional investors who can borrow shares of financial securities, which is known as financial leverage. Borrowed shares are then applied to a trade, and if the transaction goes well, the returns are greater than would be possible without the borrowed shares. In the event that a trade fails, the financial leverage creates steeper losses. Both operating and financial leverage are alike in that a risk and return profile leads to decisions surrounding the attempt to make a company's access to resources work in its favor.

Operational leverage is unique from financial leverage in that operational risk can exist even without incurring debt. This phenomenon is tied to the major costs that a business faces, including both fixed and variable. The former expenses may refer to the mortgage or rent on a building, and these costs typically remain steady for a period of time regardless of what production within the corporation resembles.

Variable costs could include compensation and other expenses relating to the operation of a business entity, such as equipment needed, and these expenses can change at a moment's notice. Similar to financial risk, operational risk can also be illustrated with a ratio. The higher that fixed costs may be in direct comparison to the evolving, or variable, costs the more operating leverage that a business has taken on. In addition to risk, operating and financial leverage share the characteristic of creating an unpredictable future, according to the Samuel Roberts Noble Foundation. This is tied to the uncertainty that variable costs as well as financial bets, such as investing, expose a business to.

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