Operating and Financial Leverage

Leverage amplifies results. In company analysis, there are two kinds. Operating leverage comes from fixed costs in the business: when sales rise, profits rise faster because costs do not grow as quickly; when sales fall, profits drop faster. Financial leverage comes from debt: borrowing magnifies returns to shareholders in good times and losses in bad times. Companies with both kinds can see enormous swings in earnings, which is why understanding leverage helps traders anticipate earnings surprises and judge risk.

Operating leverage#

Businesses with high fixed costs, such as factories, software development, airlines and semiconductor plants, have high operating leverage. Once fixed costs are covered, each additional sale contributes a large share of its revenue to profit.

degree of operating leverage (DOL) = % change in operating income / % change in revenue

Financial leverage#

Debt adds fixed interest payments. When operating income rises, more of it flows to shareholders after interest; when it falls, interest still must be paid.

degree of financial leverage (DFL) = % change in net income / % change in operating income

Common measures of financial leverage:

As a rough guide, many investment grade companies keep net debt to EBITDA below about 3x; levels above 5x to 6x are typical of leveraged buyouts and carry higher risk. See Credit Ratings.

Combined leverage#

combined leverage = DOL × DFL

A company with DOL of 3 and DFL of 2 has combined leverage of 6: a 10% fall in revenue could cut net income by about 60%.

Leverage and the business cycle#

High leverage makes companies more sensitive to economic cycles. Airlines, automakers, steelmakers and chipmakers often see profits swing from large gains to losses. In recessions, companies with high operating and financial leverage are most at risk of losses, dividend cuts and even bankruptcy. See Business and Economic Cycles and Bankruptcy and Restructuring.

Leverage and returns on equity#

Financial leverage can raise return on equity (ROE) without improving the underlying business. The DuPont formula shows this: ROE = net margin × asset turnover × equity multiplier (assets / equity). A higher equity multiplier, from more debt, lifts ROE. See ROE, ROA and ROIC.

What traders look for#

• Recovery plays: high operating leverage companies can see profits surge when sales recover.
• Downturn risk: the same companies can disappoint sharply when sales slow.
• Rising rates: heavily indebted companies face higher interest costs when refinancing. See Interest Rates.
• Debt maturities: large refinancing needs in a weak market are a red flag.

Frequently asked questions#

What is operating leverage?#

The extent to which fixed costs cause operating profit to change faster than revenue.

What is financial leverage?#

The use of debt to finance a company, which magnifies returns and risks for shareholders because interest must be paid regardless of results.

Why does leverage increase risk?#

Because it amplifies swings in profit: small declines in revenue or operating income can cause large declines in net income, or losses.

Next, learn to measure how well a company uses its capital in ROE, ROA and ROIC.