Corporate Finance
Operating and financial leverage
Operating and financial leverage magnify how a change in sales becomes a change in earnings.
Definition
Operating leverage comes from fixed operating costs: once they are covered, each extra unit of contribution falls straight to operating profit. Financial leverage comes from fixed financing costs: interest must be paid whether or not the period is good. Combined, they multiply.
Leverage is not good or bad by itself. It magnifies whatever the business already does, which is the point and the danger.
Intuition
Fixed costs are a fulcrum. The bigger the fixed base, the more a small movement in sales swings profit.
When to use it
- Assessing how sensitive earnings are to a sales downturn.
- Deciding how much debt a business can safely carry.
When not to use it
- When EBIT is near zero: both ratios explode and lose meaning.
Formula
Degree of operating leverage
DOL = Contribution ÷ EBIT
Formula
Degree of financial leverage
DFL = EBIT ÷ Profit before tax
Formula
Degree of combined leverage
DCL = DOL × DFL
The multiple by which a sales change moves earnings per share.
Worked example
Combined leverage in one pass
Contribution 800,000; fixed operating costs 500,000; interest 100,000.
- 1
EBIT
800,000 − 500,000 = 300,000.
- 2
DOL
800,000 ÷ 300,000 = 2.67.
- 3
DFL
300,000 ÷ 200,000 = 1.5.
- 4
DCL
2.67 × 1.5 = 4.0.
A 10% fall in sales lowers profit before tax by about 40%. The firm is highly operationally geared.
Measured by
These scoreboard metrics track or interpret this idea across the Lab.
Common mistakes
- Reading a high DOL as purely bad: it also amplifies upside.
- Computing leverage ratios at or near break-even where they are unstable.
- Confusing operating leverage (from costs) with financial leverage (from debt).
How it connects
is an advanced form of
The source extends the target once the basics are secure.
affects
Changing the source moves the target.
- Financial risk management: More leverage raises solvency risk.
relates to
Useful to study together, in either order.