What is Leverage?
In finance, leverage is a strategy that companies use to increase assets, cash flows and returns, though it can also magnify losses. There are two main types of leverage: financial and operating. To increase financial leverage, a firm may borrow capital through issuing fixed-income securities (loans, debt, etc), or borrowing money directly from a lender. Operating leverage can also be used to magnify cash flows and returns, and can be attained through increasing fixed operating expenses. Both methods are accompanied by risk, such as insolvency, but can be very beneficial to a business.
When a company uses debt financing, its financial leverage increases. More capital is available to boost returns, at the cost of higher interest payments, which affect net earnings.
Bob and Jim are both looking to purchase the same house that costs $500,000. Bob plans to make a 10% down payment and take a $450,000 mortgage for the rest of the payment (mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today. Who will realize a higher return on investment if they sell the house for $550,000 a year from today?
Although Jim makes a higher profit, Bob sees a much higher return on investment because he made $27,500 profit with an initial investment of $50,000 (while Jim only made $50,000 profit with a $500,000 investment).
Using the same example above, Bob and Jim realize they can only sell the house for $400,000 after a year. Who will see a lower return on investment?
Now that the sale price of the house decreased, Bob will see a much lower return on investment (-245%) compared to Jim’s return on investment of -20%.
Financial Leverage Ratio
The financial leverage ratio is an indicator of how much debt a company is using to finance its assets. A high ratio means the firm is highly levered (using a large amount of debt to finance its assets). A low ratio indicates the opposite.
The balance sheet of Companies XYX Inc. and XYW Inc. are as follows. Which company owns a higher ratio?
- Total Assets = 1,100
- Equity = 800
- Financial Leverage Ratio = Total Assets / Equity = 1,100 / 800 = 1.375x
- Total Assets = 1,050
- Equity = 650
- Financial Leverage Ratio = Total Assets / Equity = 1,050 / 650 = 1.615x
Company XYW Inc. reports a higher financial leverage ratio. It indicates that the company is financing a higher portion of their assets by using debt.
Fixed operating expenses gives a company operating leverage, which magnifies the upside or downside of its operating profit.
The income statement of Companies XYZ and ABC are the same. Company XYZ’s operating expenses are variable, at 20% of revenue. Company ABC’s operating expenses are fixed at $20.
Which company will see a higher net income if revenue increases by $50?
If revenue increases by $50, Company ABC will realize a higher net income because of its operating leverage (its operating expenses are $20 while Company XYZ’s are at $30).
Which company will realize a lower net income if revenue decreases by $50?
When revenue decreases by $50, Company ABC loses more due to its operating leverage, which magnifies the losses (Company XYZ’s operating expenses were variable and adjusted to the lower revenue, while Company ABC’s operating expenses stayed fixed).
Operating Leverage Formula
The operating leverage formula measures the proportion of fixed costs per unit of variable or total cost. When comparing different companies, the same formula should be used.
Company A and company B both manufacture soda pop in glass bottles. Company A produced 30,000 bottles, which cost them $2 each. Company B produced 45,000 bottles at a price of $2.50 each. Company A pays $20,000 in rent, and company B pays $35,000. Both companies pay an annual rent, which is their only fixed expense. Compute the operating leverage of each company using both methods.
Step 1: Compute the total variable cost
- Company A: $2/bottle * 30,000 bottles = $60,000
- Company B: $2.50/bottle * 45,000 bottles = $112,500
Step 2: Find the fixed costs
In our example, the fixed costs are the rent expenses for each company.
- Company A: $20,000
- Company B: $35,000
Step 3: Compute the total costs
- Company A: Total variable cost + Total fixed cost = $60,000 + $20,000 = $80,000
- Company B: Total variable cost + Total fixed cost = $112,500 + $35,000 = $147,500
Step 4: Compute the operating leverages
Operating Leverage = Fixed costs / Variable costs
- Company A: $20,000 / $60,000 = 0.333x
- Company B: $35,000 / $112,500 = 0.311x
Operating Leverage = Fixed costs / Total costs
- Company A: $20,000 / $80,000 = 0.250x
- Company B: $35,000 / $147,500 = 0.237x
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