Insights into Operating and Financial Leverage
by Carole E. Scott
Should a business increase or reduce the number of units it is producing? Should it rely more or less heavily on borrowed money? The answer depends upon how a change would affect risk and return. Operating leverage is the name given to the impact on operating income of a change in the level of output. Financial leverage is the name given to the impact on operating income of a change in the extent to which the firm’s assets are financed with borrowed money.
It is to the business community’s advantage for methods of financial analysis to be easy to learn and apply, but despite the fact that both operating and financial leverage are concepts that have been discussed and analyzed for decades, there is substantial disparity in how they are defined and measured, and operating leverage has been widely improperly described. An easy to understand and practical method for measuring the impact of both kinds of leverage is presented.