Understanding Leverage and Operating Leverage in Financial Management
Leverage in financial management refers to using assets or funds with fixed costs to analyze the impact of debt and equity mix on shareholder returns and risk. Operating leverage focuses on leveraging fixed operating costs to amplify profit changes with sales variations, measured by the degree of operating leverage. It is closely tied to the balance sheet, break-even point, selling price, and business risk.
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Leverage Leverage Leverage means the employment of assets or funds for which the firm pays a fixed cost or fixed return. The concept that is used to study the effects of various mix of debt and equity on the shareholder's return and risk in the capital structure of a firm is called leverage.
Types of Leverage Types of Leverage Operating Leverage Financial Leverage Combined Leverage
Meaning of Operating Leverage Operating leverage is defined as the use of fixed operating costs to magnify a change in profits relative to a given changes in sales. Contribution Operating ProfitsorContribution Operating Leverage = EBIT * EBIT = Earning before Interest & Tax *Contribution = Sales-Variable cost
Degree of Operating Leverage The multiplier effect resulting from the use of fixed operating costs can be measured by the degree of operating leverage. The degree of operating leverage (DOL) at any level of output expressed as the ratio of the percentage change in operating profits to percentage change in sales. DOL=% Change in profits % Change in Sale % Change in EBIT % Change in Sale or
Characteristics of Operating Characteristics of Operating Leverage Leverage It is related to the assets side of balance sheet. It is directly related to break-even point. It is related to selling price and variable costs. It involves business risk.
