Operating and Financial Leverage as Business Growth Tools
Companies have two main controls to improve business profitability and avoid financial distress. Used intentionally, they can compound profitability and growth. Used recklessly, they can catalyze financial distress. And that’s because operating leverage and financial leverage have the power to amplify a company’s earnings in both directions.
Modest increases in revenue can greatly enhance earnings.
Modest drops in sales can trigger dramatic losses.
What is Operating Leverage?
Operating leverage is the amplifying power of a percentage change in sales on the percentage change in operating income due to fixed operating expenses, such as rent, payroll or depreciation.
The more fixed costs a company has, the more sales it needs to generate to cover them, and that introduces significant risk into the business. In the event the company can’t generate sufficient revenue and gross margin to offset its fixed costs, it will incur an operating loss.
The effects of an operating loss are extensive, and depending on the presence of other contributing factors, they could include:
a possible operating cash flow deficit and a resulting financing requirement for the business
a reduction in net income, and in EBITDA-driven debt servicing/coverage ratios and bank covenants
a reduction in the balance sheet retained earnings, and an increase in the company’s leverage ratio
a dangerous precedent that lenders and other third parties will consider when they assess the company’s future forecast assumptions
On the other side of the challenge to cover a higher fixed cost base, operating leverage affords companies major upside opportunity. After covering fixed costs, each new dollar of revenue net of variable product costs will become straight-up profit, because fixed costs have already been covered for the entire period.
That’s the beauty of operating leverage.
high fixed costs > low variable costs > high gross margins > high operating leverage
Operating leverage is beneficial when the company is operating above its breakeven point (revenue – variable costs > fixed costs).
operating leverage ratio = fixed costs / total costs
The degree of operating leverage (DOL) calculates the percent change in EBIT expected based on a certain percent change in units sold.
DOL = contribution margin / EBIT
A DOL of 1 means that a 1% change in the number of units sold will result in a 1% change in EBIT (operating income).
What is Financial Leverage?
Financial leverage is the amplifying power of a percentage change in operating income on the percentage change in net profit due to fixed financial costs.
Financial leverage picks up where operating leverage leaves off, and is produced through the use of borrowed capital which generates fixed financial costs (such as interest expense).
The higher the use of debt in the capital structure, the higher the potential shareholder value creation but also shareholder value destruction. The potential benefits of leverage include:
larger tax deductibility
lower cost of capital compared to equity
higher investment returns
Potential risks of using leverage include:
bankruptcy from the inability to generate sufficient operating profits to service debt obligations
financial distress from the difficulty to cover debt service payments
decreased valuation from the questionable ability of the company to continue operating as a going concern
financial leverage ratio = total liabilities / total equity
For example, if you’ve got balance sheet liabilities of $4,500,000 and total equity of $8,500,000, your leverage is 0.53 or 0.53:1. If the reverse was true, your leverage would be 1.89 or 1.89:1.
Financial leverage is beneficial when the interest rate on the debt is less than the return on assets. Otherwise, you’re not going to be able to generate a large enough return on the use of the business assets to offset interest borrowing costs.
The degree of financial leverage (DFL) measures the percent change in net income based on a certain percent change in EBIT.
DFL = EBIT / net income
If a company’s DFL is 1.0, a 5% increase in operating income is expected to give rise to a 5% increase in net income.
What is the Degree of Total Leverage?
Together, the degree of operating leverage and the degree of financial leverage make up the degree of total leverage.
DTL = DOL + DFL
During periods of economic slowdown, a high degree of leverage can greatly increase business risk and its probability of financial distress. Steps you can take to protect your business under such circumstances include:
paying down debt or refinancing, to reduce, re-term or pause fixed payment obligations
temporarily outsourcing or switching fixed expenditures to variable as appropriate, to maintain the various business functions without the associated burden of fixed costs