Operating and financial leverage both will result in the magnification of changes to earnings due to the presence of fixed costs in a company’s cost structure. Financial leverage is the enlargement on the bottom half of the income statement on how earnings per share changes in response to changes in EBIT, the pertinent fixed costs is the fixed cost of financing in particular interest. Operating leverage is the enlargement on the top half of an income statement on how EBIT changes in response to changes in sales, the pertinent fixed cost is the fixed cost of operating the business.
Operating leverage can be calculated by dividing the difference between sales revenue and variable cost by the difference between sales revenue and total costs.
If a company has $10,000 in sales revenue, $5,000 in variable costs, $2,000 if fixed costs (therefore $7,000 in total costs), its operating leverage would be ($10,000-$5,000)/ ($10,000-$7,000) =1.67. On the other hand, if that same company had $2,000 in variable costs and $5,000 in fixed costs, which results in the same total costs of $7,000, its operating leverage would be ($10,000-$2,000)/($10,000-$7,000)=2.67 (http://www.ehow.com/info).
A positive financial leverage means that the assets acquired with the funds provided by creditors and preferred stockholders generate a rate of return that is higher than the rate of interest or dividend payable to the providers of funds. Positive financial leverage is beneficial for common stockholders. For example, XYZ Company obtains a long term debt at a rate of 12%. The company can use the funds to earn an after-tax rate of 14%. The interest on debt is tax deductible. If the tax rate is 40%, the after-tax interest rate would be 7.2% [12% × (1 – 0.4)]. The difference of 6.8% (14% – 7.2%) is, therefore, the benefit of common stockholders.
A negative financial leverage occurs when the assets acquired with the debts and preferred stock generate a rate of return that is less than the rate of interest or dividend payable to the providers of debts or preferred stock. Negative financial leverage is a loss for common stockholders.
Brigham, E. F., & Houston, D. J. F. (2014). Fundamentals of Financial Management, Concise Edition (with Thomson ONE – Business School Edition 6-Month Printed Access Card), 8th Edition. [VitalSource Bookshelf version]. Retrieved from http://digitalbookshelf.southuniversity.edu/books/9781305217218/outline/13
Corporate Finance – Effects of Debt on the Capital Structure. Retrieved from www.investopedia.com/…/debt-effects-capital-structure.asp
What Effect Does Operating Leverage Have on a Company’s Profits? Retrieved from http://www.ehow.com/info