What is Leverage?
The Meaning of Operating, Financial, and Combined Leverage
Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of inventory, equipment and other company assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also increases the company's returns; specifically its return on equity. This is true because, if debt financing is used rather than equity financing, then the owner's equity is not diluted by issuing more shares of stock.
With debt financing, regardless if whether the interest charges are from a loan or line of credit, the interest payments are tax deductible. In addition, by making timely payments a company will establish a positive payment history and business credit rating.
Investors in a business prefer the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company's default risk.
There are three types of leverage:
What is Operating Leverage?
Breakeven analysis shows us that there are essentially two types of costs in a company's cost structure -- fixed costs and variable costs. Operating leverage refers to the percentage of fixed costs that a company has. Stated another way, operating leverage is the ratio of fixed costs to variable costs. If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage. These firms use a lot of fixed costs in their business and are capital intensive firms.
A good example of capital intensive business firm are the automobile manufacturing companies. They have a huge amount of equipment that is required to manufacture their product - automobiles. When the economy slows down and fewer people are buying new cars, the auto companies still have to pay their fixed costs such as overhead on the plants that house the equipment, depreciation on the equipment, and other fixed costs associated with a capital intensive firm. An economic slowdown will hurt a capital intensive firm much more than a company not quite so capital intensive.
You can compare the operating leverage for a capital intensive firm, which would be high, to the operating leverage for a labor intensive firm, which would be lower. A labor intensive firm is one in which more human capital is required in the production process. Mining is considered labor intensive because much of the money involved in mining goes to paying the workers. Service companies that make up much of our economy, such as restaurants or hotels, are labor intensive as well. They all require more labor in the production process than capital costs.
In difficult economic times, firms that are labor intensive typically have an easier time surviving than capital intensive firms.
What does operating leverage really mean? It means that if a firm has high operating leverage, a small change in sales volume results in a large change in EBIT and ROIC, return on invested capital. In other words, firms with high operating leverage are very sensitive to changes in sales and it affects their bottom line quickly.
Business risk is just one portion of the risk that determines a business firm's future return on equity. Business risk is the risk that a firm's shareholders face if the firm has no debt. It is the risk inherent in the firm's operations. It rises from economic uncertainty which leads to uncertainty about future profits and capital requirements.
One component of business risk is variability in product demand. Customers always have to have food so in difficult economic times, the Publix grocery store chain will have less product variability than Ford Motor Company. Customers don't have to buy new cars during periods of economic uncertainty. Most business firms also have variability in product sales prices and input costs. Firms that are slower to bring new products to market expose themselves to more business risk. Think of the American automobile companies.
Foreign car companies brought fuel efficient cars to market faster than American car companies, exposing them to more business risk.
If a business firm has high fixed costs and their costs do not decline as demand declines, then the firm has high operating leverage which means high business risk.
What is Financial Leverage?
Financial leverage refers to the amount of debt in the capital structure of the business firm. If you can envision a balance sheet, financial leverage refers to the right-hand side of the balance sheet. Operating leverage refers to the left-hand side of the balance sheet - the plant and equipment side. Operating leverage determines the mix of fixed assets or plant and equipment used by the business firm. Financial leverage refers to how the firm will pay for it or how the operation will be financed.
As discussed earlier in this article, the use of financial leverage, or debt, in financing a firm's operations, can really improve the firm's return on equity and earnings per share. This is because the firm is not diluting the owner's earnings by using equity financing. Too much financial leverage, however, can lead to the risk of default and bankruptcy.
One of the financial ratios we use in determining the amount of financial leverage we have in a business firm is the debt/equity ratio. The debt/equity ratio shows the proportion of debt in a business firm to equity.
What is Combined, or Total, Leverage
Combined, or total, leverage is the total amount of risk facing a business firm. It can also be looked at in another way. It is the total amount of leverage that we can use to magnify the returns from our business. Operating leverage magnifies the returns from our plant and equipment or fixed assets. Financial leverage magnifies the returns from our debt financing. Combined leverage is the total of these two types of leverage or the total magnification of returns. This is looking at leverage from a balance sheet perspective.
It is also helpful and important to look at leverage from an income statement perspective. Operating leverage influences the top half of the income statement and operating income, determining return from operations. Financial leverage influences the bottom half of the income statement and the earnings per share to the stockholders.
The concept of leverage, in general, is used in breakeven analysis and in the development of the capital structure of a business firm.