How Is Risk Related to Operating and Financial Leverage?

Just as stock and cryptocurrency traders can amplify their gains and losses through margin, so can business owners. There are two major types of leverage at the disposal of businesses: 

• Operating leverage — growing a business using fixed cost
• Financial leverage — using debt and equity financing to grow a business

However, there are risks in both types of leverage. That is where the “losses” part comes in. These potential losses are due to leverage. Leverage works both ways. Just as a lot of leverage can send profits soaring, it can also decimate a business.

What Is Operating Leverage?

Operating leverage measures how responsive operating income is to a change in sales volume. This measure is called DOL or degree of operating leverage. 

By operating leverage, we are referring to fixed costs. A company with high fixed costs and low variable costs will see higher profits as more units are sold. This is because a large contributing factor to profits is fixed cost.

It also works the other way — as units sold drop, so do profits. We can see the impact of leverage as fixed cost increases. In this case, a company must sell more units to achieve a higher profit. An increase in fixed costs coupled with a dip in units sold will quickly decrease profits and can even begin wiping them out.

To see how operating leverage works, let’s look at the DOL formula:

DOL = Q(P-V)  / [(P-V) - F]

Q = quantity of units sold

V = variable cost

P = price per unit

F = fixed cost

Q(P-V) equals income based on units sold. The formula can also be expressed as: 

contribution margin / operating income

DOL provides a ratio. A DOL of 1 means there is no leverage being used. The best way to see how DOL works is with a couple of examples.

Company A:

Sales = $5,000

Variable cost = $500

Fixed Cost = $2000

First, calculate the company’s profit: $5,000 - $500 - $2,000 = $2,500

Then its DOL:  ($5,000 - $500) / $2,500 = 1.8

Company B:

Sales = $5,000

Variable cost = $1500

Fixed Cost = $1000

Profit: $5,000 - $1500 - $1,000 = $2,500

DOL: ($5,000 - $1,500) / $2,500 = 1.4

How do we interpret the DOL values? As the impact of sales on profit. A 10% sales increase in both companies results in profit increases of:

Company A: 10% x 1.8 = 18%

Company B: 10% x 1.4 = 14%

However, the same is true of a 10% drop in sales. Company A will see profits fall by 18%, while Company B will see profits fall by 14%. Big moves in sales can contribute to big impacts negatively and positively on operating income.

A low DOL equals low risk but also low reward. Remember that operating leverage does not include fixed financing costs because those are not operating costs. That is the subject of the next section.

What Is Financial Leverage?

Financial leverage is similar to brokerage margin. Traders utilize brokerage margin to lever up gains in their trades. In the same way, businesses can utilize financing to boost their revenues. However, just like operating leverage, it cuts both ways.

Financial leverage consists of equity and debt financing. Equity financing consists of investor funds or other sources of outside money. Equity financing profits through return on investment or return on equity (ROE). As the business grows and generates profits, equity investors benefit.

Debt financing is basically a loan. Debt investors don’t participate in the business’ upside as equity investors do. For this trade-off, debt investors receive regular payments of interest, just like a mortgage company receives regular payments from homeowners.

Debt investors have one other advantage. Should the business file for bankruptcy, debt investors are usually first in line to receive their principal (or whatever is leftover). On the other hand, equity investors generally come last in the capital stack.

Let’s look at some examples to see how financial leverage works. In the following table, ROA is the return on assets. E. Leverage is equity leverage.

You can see that as equity drops, its returns and leverage increase significantly, even as net income drops. However, in this example, we are looking at the world through rose-colored glasses. What happens if net income drops by $300 while the company is 5X leveraged?

We end up with the following:

Leverage makes everything look great during good times but when things go wrong, they can come apart in a hurry.

This isn’t to say that leverage should be looked at negatively. Used with caution and a measured approach, leverage can be a useful tool for the growth of most any business.

^{This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only.}