Operating Leverage vs Financial leverage

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Operating Leverage vs Financial leverage (Differences)

Operating Leverage vs. Financial Leverage – Leverage is a firm's ability to employ new assets or funds to create better returns or reduce costs. That's why leverage for any company is very significant.

There are two kinds of leverage – operating leverage and financial leverage. When we combine the two, we get a third type of leverage – combined leverage. Since both (operating leverage and financial leverage) are quite different, and we look at different metrics to calculate them, we need to discuss them in detail to understand them better.

operating leverage vs financial leverage
  • Operating leverage can be defined as a firm's ability to use fixed costs (or expenses) to generate better returns for the firm.
  • Financial leverage can be defined as a firm's ability to increase better returns and reduce the firm's cost by paying less taxes.

On the one hand, operating leverage compares how well a firm uses its fixed costs and financial leverage; on the other hand, it looks at various capital structures and chooses the one that reduces taxes most.

In this article, we at the comparative analysis of operating leverage vs. financial leverage.

Let's get started with the head-to-head differences between operating and financial leverage in infographics without any ado.

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Operating Leverage vs. Financial leverage Infographics

Let’s look at the top differences between operating leverage and financial leverage below –

Operating-Leverage-vs-Financial-leverage

Explanation of Operating Leverage in Video

 

Operating Leverage vs. Financial leverage (Comparison Table)

Basis for Comparison between Financial Leverage vs. Operating LeverageOperating LeverageFinancial Leverage
1.    MeaningOperating leverage can be defined as a firm’s ability to use fixed costs to generate more returns.Financial leverage can be defined as a firm’s ability to use capital structure to earn better returns and to reduce taxes.
2.    What it’s all about?It’s about the fixed costs of the firm.It’s about the capital structure of the firm.
3.    MeasurementOperating leverage measures the operating risk of a business.Financial leverage measures the financial risk of a business.
4.    CalculationOperating leverage can be calculated when we divide contribution by EBIT of the firm.Financial leverage can be calculated when we divide EBIT by EBT of the firm.
5.    ImpactWhen the degree of operating leverage is higher, it depicts more operating risk for the firm and vice versa.When the degree of financial leverage is higher, it depicts more financial risk for the firm and vice versa.
6.    In relation withThe degree of operating leverage is usually higher than Break Even Point.Financial leverage has a direct relationship with the liability side of the balance sheet.
7.    How much is it preferred?The preference is lower.The preference is much higher.

Conclusion

Operating leverage and financial leverage are both critical in their terms. And they both help businesses in generating better returns and reduce costs. So the question remains: can a firm use both of these leverages? The answer is yes.

If a company can use its fixed costs well, it would be able to generate better returns just by using operating leverage. And at the same time, they can use financial leverage by changing their capital structure from total equity to 50-50, 60-40, or 70-30 equity-debt proportion. Even if changing the capital structure would prompt the company to pay interests; still, they would be able to generate a better rate of returns and would be able to reduce the amount of taxes at the same time.

That's why using operating leverage and financial leverage is a great way to improve the company's rate of returns and reduce costs during a particular period.