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Leverage Effect Measures

Understanding effects of financial and operational leverage on a business

What are Leverage Effect Measures?

Leverage effect measures aim to quantify how much business risk a given company is currently experiencing. Business risk refers to the revenue variance that a business can expect to see, and how sensitive net income is to changes in revenues. Leverage effect measures aim to show how the business’ fixed and variable costs can impact profitability when revenues change. In this article, we will be looking at the Operational Leverage Effect (OLE), Financial Leverage Effect (FLE), and Total Leverage Effect (TLE) ratios.

 

Leverage Effect Measures

 

Operational Leverage Effect Measure

The operational leverage effect is used to generate an estimate of how changes in ROA (return on assets) and net income are related to changes in sales volume. The measure is particularly useful for businesses that operate with fairly high fixed costs and that tend to see quite a bit of variance in their revenues.

To calculate the Operational Leverage Effect Measure (OLE), we can use the following formula:

 

Leverage Effect Measures - OLE

 

If a company reports an Operational Leverage Effect that is greater than 1, the company is said to be operationally leveraged (i.e., with fixed costs). The significance of the operational leverage depends on how the company’s OLE compares to the OLE of competing firms. Looking at how the company’s OLE changes over time also enables us to gain insight about the business.

If the OLE is equal to 1, then all costs incurred by the company are variable. Thus, an increase or decrease in sales would lead to a proportional increase or decrease in ROA.

 

Financial Leverage Effect Measure

Organizations that utilize debt in their capital structure face more business risk than purely equity-financed organizations. Since such companies are obligated to make regular interest payments to lenders, they are also more operationally leveraged. This is because there will always be a cash drain – interest payments – that may hinder the company’s profitability. Investors consider companies that utilize a lot of debt financing as riskier. This is because the more debt a company takes on, the higher the probability of the company defaulting on its loans.

To measure the financial leverage effect, we can use the following equation:

 

Leverage Effect Measures - FLE

 

The FLE measure can be used to quantify the sensitivity of net income to operating income. The main items separating these figures are the company’s interest payments, taxes, and depreciation and amortization. Those costs are highly dependent upon the company’s capital structure. FLE aims to measure the degree of financial leverage that a business faces, based on its capital structure.

Suppose a given business’ FLE is 1.5. That means that if its operating income increases by 10%, its net income would increase by 15%. You find the effect on net income by multiplying the change in operating income by the FLE number.

 

Total Leverage Effect Measure

The Total Leverage Effect (TLE) is a combination of both the FLE and OLE. It can be calculated using the following equation:

 

Leverage Effect Measures

 

The TLE measure aggregates both the FLE and OLE measures into a single number that aims to encompass the business’ overall state of leverage. The TLE takes into account all of the financial and operational leverage that a business faces, and quantifies the company’s overall business risk due to leverage.

TLEs can be calculated for several companies in the same industry to see which businesses are most leveraged. The historical TLEs for a company can also be looked at to see whether the business is trending, over time, toward being more, or less, leveraged.

 

Additional Resources

Thank you for reading CFI’s explanation of Leverage Effect Measures. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • NPV Function
  • Internal Rate of Return (IRR)
  • Payback Period
  • DCF Model Template

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