Relationship between financial and operating leverage:
In business terminology, leverage is used in two senses: Financial
leverage & Operating Leverage
Financial leverage: The effect which the use of debt
funds produces on returns is called financial leverage.
Operating leverage: Operating leverage refers to the
use of fixed costs in the operation of the firm. A firm has
a high degree of operating leverage if it employs a greater
amount of fixed costs. The degree of operating leverage may
be defined as the percentage change in profit resulting from
a percentage change in sales. This can be expressed as:
= Percent Change in Profit/Percent Change in Sales
The degree of financial leverage is defined as the percent
change in earnings available to common shareholders that is
associated with a given percentage change in EBIT. Thus, operating
leverage affects EBIT while financial leverage affects earnings
after interest and taxes the earnings available to equity
shareholders. For this reason operating leverage is sometimes
referred to as first stage leverage and financial leverage
as second stage leverage. Therefore, if a firm uses a considerable
amount of both operating leverage and financial leverage even
small changes in the level of sales will produce wide fluctuations
in earnings per share (EPS). The combined effect of both these
types of leverages is after called total leverage which, is
closely tied to the firm's total risk.
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