What are Leverage Effect Measures?
Leverage effect measures aim to quantify how much business risk a given company currently experiences. 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.
Operational Leverage Effect
The operational leverage effect is used to generate an estimation 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 (OLE), we can use the following formula:
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 extent 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 will also enable us to draw further insight about the business.
If 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
Organizations that utilize debt in their capital structure face more business risk that purely equity-financed organizations. Since such companies are legally obligated to make monthly interest payments to debt providers, they are also more operationally leveraged. It is because there will always be a cash drain in the form of interest payments that may hinder the company’s profitability. Investors consider companies that utilize a lot of debt financing as riskier since 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:
The FLE measure can be used to quantify the sensitivity of the net income to the operating income. The main items separating both figures are the company’s interest payments, taxes, and depreciation and amortization. The costs are highly dependent upon the company’s capital structure. We can now see how 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. It would mean that if its operating income were to increase by 10%, its net income would increase by 15%.
Total Leverage Effect
The Total Leverage Effect (TLE) is a combination of both the FLE and OLE. It can be calculated using the following equation:
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 a variety of companies competing in the same industries and compared against each other to understand which businesses are most leveraged. The TLEs for a single company can also be compared to one another to understand time-bound trends in its financial history.
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: