A. Operating leverage and financial leverage are two types of leverage that refer to how a company uses debt to amplify the returns on its operations or investments.
Operating leverage is the extent to which a company’s operations are financed with fixed costs, such as salaries and rent, as opposed to variable costs, such as materials and labour. A company with a high degree of operating leverage will have a larger proportion of fixed costs in its cost structure, which can amplify the impact of changes in revenue on its profitability. A company with high operating leverage will be more sensitive to revenue changes, and hence, more volatile in its earnings.
Financial leverage, on the other hand, refers to the extent to which a company uses debt to finance its operations and investments. A company with a high degree of financial leverage will have a larger proportion of debt in its capital structure, which can amplify the impact of changes in earnings on its return on equity. Financial leverage can increase the returns on equity for shareholders, but it also increases the risk of default if the company’s earnings decline.
A company usually cannot control operating leverage as that is determined by the industry in which it operates. But it can decide its financial leverage by adjusting capital structure. Companies with high OL should aim for lower FL, and vice versa
