In finance, we have three types of leverage or ways to “leverage” a company, which are:
- Operating leverage or operating lever.
- Financial lever or financial leverage.
- Combined, total or mixed leverage.
Types of Leverage
Here are the three types of leverage.
Operating leverage seems like a sophisticated concept of finance, reserved for corporations. However, every business (however small it may be) has an “operating lever”.
Operating leverage is a concept that arises with the mere presence of fixed costs within the costing or cost structure of the business.
A boost in sales below a certain level of fixed costs results in higher operating profit, as a fixed component of cost is divided into ever-increasing sales.
Finance experts allude that operating leverage is a “first-phase leverage” that magnifies or amplifies earnings in the face of a change in sales volume.
In short, operating leverage is the use of fixed operating costs to magnify the effect of the change in sales on operating profit (called EBIT or UAII).
Operating leverage formula
The simplest formula to determine the operational leverage or degree of operational leverage of business is:
Degree of Operating Leverage (GAO) = (Δ% of UAII) / (Δ% of sales) or the percentage change in operating profit over the percentage change in sales.
This formula applies when we have the financial results of two consecutive periods or when we want to contrast an expected scenario with a current scenario.
Another formula for operating leverage
Another operating leverage formula is: GAO = Q * (Pv – CVu) / [Q * (Pv – Cvu) – CFt]
- “GAO” is the degree of operating leverage.
- “Q” is the number of units sold.
- “Pv” is the sale price of the item.
- CVu is the variable cost per unit.
- “CFt” is the total fixed costs.
In much simpler terms, we have that the degree of operating leverage is GAO = (Vtas – CVT) / (Vtas – CVT – CF).
Any result in the application of these formulas must give a GAO greater than 1.
A GAO of 2, for example, means that an impact on sales of 1% will result in an impact on operating profit before interest and taxes (EBIT or UAII) of 2%.
But remember that this effect can occur both in increases and decreases in sales. If you have a 1% setback in sales with a GAO equal to 2, you will have a 2% setback in operating profit.
Definition of Operating Leverage
Operational leverage takes place in the presence of fixed costs in the company’s cost structure. If you pay rents, fees, insurance premiums, you may already experience an operating lever.
It is based on the fact that a favorable impact on sales will increase operating profit by the same or a higher percentage since increasingly higher sales are divided between the same component of fixed costs.
Financial experts claim that operating leverage is largely linked to the company’s economic structure and investment decisions.
This is because fixed assets give rise to fixed operating costs, which in turn translate into operating leverage.
Operation lever is referred to as a double-edged sword since greater leverage brings greater risk. Operating leverage gives rise to “operating risk”.
The operational risk or business risk is simply the risk of not being able to cover fixed operating costs. “Higher costs, greater risk.”
The higher the fixed operating costs, the greater the operating leverage and operating risk of the business.
Characteristics of operating leverage
The following are some of the characteristics of the so-called operating leverage:
- It is generated thanks to the fixed operating costs or fixed assets of a business or company.
- It measures the relationship between sales revenue and operating profit in terms of the percentage change.
- It gives rise to “operations risk” or business risk in a company that materializes due to the impossibility of covering fixed costs.
- It is higher in manufacturing companies that have a huge amount of fixed operating costs and lower in a commercial or service company that requires much less investment in fixed assets.
The second type of leverage is the financial lever and it has a lot to do with the fiscal shield or the fixed charge maneuvers that are carried out to achieve a lower taxable income, thus favoring the profit or the result for investors.
Leveraging a company from the financial context seems to be reserved for large companies, but it is enough to get a loan to experience financial leverage.
Remember that interest is a type of “fixed charge” within the business cost structure, which is tax-deductible.
The financial lever is considered second-degree leverage, which begins where the operational leverage ends.
A financial x leverage of percent indicates that for each percentage point that the profit before interest and taxes (UAII or EBIT) varies, the final result or also the earnings per share (EPS) will vary in x percent.
Types of financial leverage
We cannot speak directly of types of financial leverage, although we have different contexts where it applies.
The financial lever
We have the financial leverage, inherent to going businesses that have fixed charges in their financial structure, subject to a tax deduction and, with this, offer a multiplier effect on net profit.
So we can also talk about FOREX leverage to refer to the practice that many forex brokers offer, through which they offer a lever of 1:10 or 1:50 or even 1: 100.
This means that for every dollar you invest in their portfolios, they will contribute and multiply the return (or losses) by 10, 50, or even 100 (depending on the degree of appeasement they offer).
As you will see, it is a double fixed weapon, because if the result is not favorable, you will end up owing a good amount of money, which is somewhat probable.
CFDs, acronyms for the English term ” Contract for Difference” or “contracts for difference”, can also be seen as a type of financial leverage.
In a contract for difference, two parties (a buyer and a seller) agree to exchange the “difference” between the starting and closing value of an asset, such as stocks, cryptocurrency, bonds, portfolios … but the asset is not purchased as such.
It is basically a bet to raise or lower the value of the asset during a certain period in which a return similar to the change in the asset will be obtained.
In this type of operation, financial leverage is almost always provided, since it operates with more money than is contributed, thereby increasing the possible profit or loss.
If you want more details of this type of bet, consult portals such as Avatrade or eToro.
Example financial leverage
The most typical case of financial leverage occurs when you get into debt (either with a third party or an individual) with a bank or with an entity of the popular financial system.
You acquire a team, a vehicle, or raw materials for your business that, otherwise, you could not buy with only your own resources, you are leveraging there, but not only that.
When you take a loan to buy equipment or machines for your business, you are obliged to return the capital loaned and interest that is tax-deductible.
The interests will make you end up paying less tax to the treasury compared to the case that you had not got into debt. Another effect of leverage.
Another example of financial leverage
Suppose an investment bank presents the irresistible offer of a 15% annual promissory note for the minimum investment of MX $ 100,000. After a year, you will get MX $ 115,000.
But what if your grandfather lends you another hundred thousand and tells you to pay him with 5% annual interest. You collect MX $ 200,000 and invest them in promissory notes.
At the end of the year, you will get 230,000 pesos; you pay your grandfather MX $ 105,000 and you end up with MX $ 125,000; You have generated ten thousand pesos more than if you had invested only your one hundred thousand.
You financed a significant part of the investment with debt and have increased your profits.
That is pure financial leverage and is constantly applied by large companies.
When should we leverage?
When you are sure that the income you will generate with the investment, measured or not in percentage, is higher than the cost of the capital invested, which can be the interest rate plus commissions and other charges.
Characteristics of financial leverage
Financial leverage brings with it peculiarities such as:
- It occurs when there are “fixed financial costs” or “debt capital” in the financial structure of a company.
- It is the direct relationship between operating profit (EBIT or UAII) and net profit or earnings per share (EPS).
- Financial leverage gives rise to “financial risk” in a business, which is the risk of insolvency or of not being able to pay the debts incurred.
- It will be higher as the company gets more indebted or gets a lot of debt.
Financial leverage formulas
The formula to measure the degree of financial leverage or GAF is (Δ% of EPS) / (Δ% of EBIT), remembering that EBIT is the same as UAII.
This formula is used to measure the degree of financial leverage between one period and another or between a current and a proposed scenario.
We also have the following formula to measure the financial leverage ratio of an investment proposal:
GAF = (total amount to invest / own funds) x [UAII / (UAII- I)]
- “GAF” is the degree of financial leverage of a business or investment proposal.
- The total amount to invest is the amount of money that will go to the project or investment, includes own funds and borrowed money.
- Own funds, the capital of the project proponents.
- “UAII” is the profit before interest and tax or operating profit of the company.
- “I” is the total amount of interest to pay.
A much simpler expression to measure financial leverage is
GAF = (EBIT) / (EBT) or GAF = [UAII / (UAII- I)]
How do you read financial leverage?
If a company’s financial leverage value is “Y”, we can say that an increase of X% in the operating profit of the business will increase net profit or EPS of X% * Y.
For example, if the degree of financial leverage is 1.50, an increase of 1% in UAII will result in a favorable variation of 1.5% in EPS or the net result of the business.
The same is true of an unfavorable result. For example, if the company falls 1% in operating profit and they have a GAT of 1.5, the result will be a 1.5% drop in net profit.
Total, mixed, or combined leverage is the joint effect of operating leverage and financial leverage.
According to the academic portal Ecured, total leverage is the maneuver that the financial management of the company undertakes when addressing “fixed costs and fixed financial charges” in search of an increase in the result of the business due to the increase in sales.
The most commonly used formula to calculate the combined degree of leverage (GAC or GAT) is (Δ% of EPS) / (Δ% of sales).
Also the total or combined leverage comes from the product between the operating lever by the financial lever.
GAT = GAO x GAF.
Examples of leverage
When a business has “fixed costs” within its costing or expense structure such as rentals, payment of services, insurance; although you may not know it, you are doing operational leverage.
When your sales are boosted, fixed costs will become less and less in the face of increasing profits.
If the business owner decides to go into debt for productive purposes (in other words, ask for a credit to buy equipment or supplies used in the business), he will be achieving financial leverage, provided that he drives his sales in a greater proportion than the payment of interest on credit.
If both situations occur in a business, we will have the effect of “combined leverage”.
If for academic purposes you want to delve into examples of calculating leverage, you can consult the thesis presented by Machala in 2017, which is entitled “ calculation of the operational, financial and total leverage of Almacenes López Jr. ”
Leverage, whether operational, financial, or combined, is calculated and interpreted in percentage terms.
A result of 2 in an operating leverage index reads: “For every 1% increase in sales, profit before interest and taxes will increase 2%.”
The same result for the financial lever will be: “For each percentage point that increases in operating profit, the net profit will increase twice in percentage terms.”
Regarding a value of 2 in the total or combined leverage ratio, we will say: “for every 1% that sales increase, net profit (or earnings per share) will increase by 2%.
Regardless of the type of leverage, a desirable result must be greater than 1, an indicator value less than 1 is not desirable or is inapplicable.
Financial and operational leverage
Financial leverage is called by experts “second-degree leverage”, which begins when the trading lever ends.
The financial management of a company uses the financial lever when it incorporates fixed costs and charges into the financial structure of the business to “magnify” any change in the net result (or EPS) from a change in operating profit ( UAII or EBIT).
At a simpler level is operating leverage, similar in certain respects to the financial lever. The operation is the use of fixed costs in the costing structure of the company to amplify the variation in profit before interest and taxes due to a change in the level of sales.
If you are passionate about financial slang, I invite you to take into account the reading of our delivery business plan, what is it, and what is its use?
Total leverage also called mixed or combined leverage, is the joint action of the operating lever and the financial lever.
This “total leverage” collects or quantifies the “total or combined risk” that the company is assuming due to the fixed costs, financial charges, and debts it owns.
For the English portal Business Management Ideas, total leverage “explains the complexity of business risk.”
It turns out that an entrepreneur rents premises, furniture, and equipment, invests in the capital, pays his salary, and carries with him the urge to cover all those costs from income, which translates into “operational risk”.
Not in accordance with this, the entrepreneur is obliged to return the foreign capital invested and also pay interest and other charges if he commits to creditors (this will be the “financial risk”).
So a degree of total leverage (GAT) is a measure of the total risk of a company and is calculated through the product between the degree of operating leverage (GAO) and the degree of financial leverage (GAF).
The term refers to leverage, “support mechanisms” that allow “expanded results” by investing a smaller proportion of resources.
Leverage is not synonymous with indebtedness, although it is a result that can be achieved when yields greater than the cost of invested capital are generated.
Purpose and Benefits of Leverage Ratio
The following are the objectives and benefits of the leverage ratio, among others.
- So that the company can find out its position on various obligations to creditors.
- So that the company can assess its ability in the process of fulfilling obligations that have a fixed nature, such as loan installments and interest.
- So that the company can assess the balance between the value of assets (especially fixed assets) with capital.
- So that companies can determine and assess the level of influence of debt on an asset management.
- So that the company can assess the amount of assets of the company that can be financed by debtors.