QUESTION: Difference between Operating leverage and financial leverage?
Answer:
DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE
| Basis of difference | Operating leverage | Financial leverage |
| Meaning | Use of the such assets in the company’s operations for which it has to pay fixed costs is known as operating leverage. | Use of debt in capital structure of company for which it has to pay interest expenses is known as financial leverage. |
| Measures | It measures the effect of operating costs. | It measures the effect of interest expenses. |
| Relates | It relates the sales and EBIT. | It relates to the EBIT and EPS. |
| Preferable | The operating leverage should be low as it ensures that there is low level of operating risk. | The financial leverage should be high as it shows that the firm will incur profit only when the operating profit or contribution is rising. |
| Formula | Contribution/ EBIT | EBIT/EPS |
| Risk | It gives rise to business risk. | It gives rise to financial risk. |
| Degree | Percentage change in EBIT/ Percentage change in sales | EBIT/ EBIT-I Or EBIT/ EBT |
| Cost/ Capital structure | It is determined by the cost structure of the firm. | It is determined by capital structure of the firm. |
| Concerned with | It is concerned with investing activities of firm. | It is concerned with financing activities of the firm. |
| Calculates | It calculates the operating risk associated with mix of variable and fixed operating expenses. | It calculates the financial risk associated with choice of sources of funds for financing the business. |
| Nature | It may be favourable or unfavourable to the organisation. | It may be positive or negative to the earnings of the organisation. |
| Impact when higher | High DOL shows the higher degree of business risk to the firm. | High DFL shows the higher degree of financial risk to the firm. |
| Impact when ideal | Low DOL is situation which the firm’s sales revenues are more when compared to the operating costs. | High DFL is the situation in which the firm earns more from the assets purchased with the funds than the cost of funds. |
| ALSO STUDY: |
| Sources of finance |
