| Definition |
Use of fixed financial costs (like interest on debt) to magnify returns to equity shareholders. |
Use of fixed operational costs (like rent, salaries) to magnify the effect of changes in sales on operating income. |
| Focus Area |
Capital structure and financing decisions. |
Cost structure and operational efficiency. |
| Related To |
Debt vs equity in the financing mix. |
Fixed vs variable costs in the business model. |
| Costs Involved |
Fixed financial costs like interest payments. |
Fixed operating costs like depreciation, rent, and salaries. |
| Risk Type |
Financial risk – risk of default due to inability to meet interest obligations. |
Business risk – risk due to fixed costs regardless of sales volume. |
| Effect on Profit |
Magnifies changes in EBIT into larger changes in EPS. |
Magnifies changes in sales into larger changes in EBIT. |
| Degree Measurement |
Degree of Financial Leverage (DFL) = % change in EPS / % change in EBIT |
Degree of Operating Leverage (DOL) = % change in EBIT / % change in Sales |
| High Leverage Implication |
High debt = more risk but potential for higher returns to shareholders. |
High fixed costs = more sensitivity of profits to changes in sales. |
| Control |
Controlled by financing strategy (taking or avoiding debt). |
Controlled by cost structure (automation, outsourcing, etc.). |
| Example Scenario |
Company takes loans to finance expansion; interest payments remain fixed. |
Company operates factories with high fixed costs, regardless of sales. |
| Impact During Growth |
Higher profits go to equity holders after interest payments – boosting EPS. |
Increase in sales leads to higher operating profit due to fixed cost absorption. |
| Impact During Decline |
Falling EBIT drastically reduces EPS and may lead to losses or default. |
Falling sales lead to lower EBIT due to inflexible cost base. |
| Strategic Implication |
Used when confident of generating higher returns than interest costs. |
Used when confident of maintaining or growing sales volume steadily. |
| Nature of Leverage |
Financing-related leverage. |
Business operations-related leverage. |
| Combined Impact |
Combining both can lead to high total risk but also high reward potential. |
When combined with financial leverage, can create significant total leverage. |
| Key Metric Affected |
Earnings Per Share (EPS) |
Operating Income (EBIT) |
| Relevant To |
Financial managers and investors analyzing capital structure. |
Operations and production managers focusing on cost control and pricing. |
| Graphical Representation |
Shows impact on EPS due to changes in EBIT. |
Shows impact on EBIT due to changes in Sales. |
| Industry Example |
Banking, telecom, and capital-intensive industries with high debt use. |
Manufacturing, airline, and hotel industries with high fixed operating costs. |
Financial Leverage vs Operating Leverage