LEVERAGES

The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return maybe termed as leverage.

OPERATING LEVERAGE – Operating Leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.

FINANCIAL LEVERAGE – Financial Leverage can be defined as the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the earnings per share.

i). Operating Leverage results from the existence of fixed operating expenses in the firm’s income stream whereas Financial Leverage results from the presence of fixed financial charges in the firm’s income stream.

ii). Operating Leverage is determined by the relationship between a firm’s sales revenues and its earnings before interest and taxes. (EBIT)Financial Leverage is determined by the relationship between a firm’s earnings before interest and tax and after subtracting the interest component.

iii). Operating Leverage = Contribution / EBIT

Financial Leverage = EBIT / EBT

iv). Operational Leverage relates to the Assets side of the Balance Sheet, whereas Financial Leverage relates to the Liability side of the Balance Sheet. v). Operational Leverage affects profit before interest and tax, whereas Financial Leverage affects profit after interest and tax.

vi). Operational Leverage involves operating risk of being unable to cover fixed operating cost, whereas Financial Leverage involves financial risk of being unable to cover fixed financial cost.

vii). Operational Leverage is concerned with investment decisions, whereas Financial Leverage is concerned with financing decisions.

viii). Operating Leverage is described as a first stage leverage, whereas Financial Leverage is described as a second stage leverage.