Accounting 101: What is leverage?

One of the terms often bandied about in the corporate world and in the financial press is ‘leverage’. It can be the sort of terminology where you ‘kind of know’ what it means, but if you’re setting up a high growth business, it’s something you definitely need to understand. There are two kinds of leverage: financial leverage and operating leverage. When used well they can be key drivers for growth and profitability, but misuse of leverage may have serious consequences, as many believe overleverage played a big part in the 2008 Global Financial Crisis.

Financial leverage explained.

Financial leverage is an investment strategy of using borrowed money to increase the potential return of an investment. It can be defined as the impact of a percentage change in operating income on the percentage change in net profit, due to fixed financial costs (interest).

The higher the use of debt in the capital structure, the higher the potential benefits (tax deductibility, lower cost of capital, higher returns, increased shareholder value), equally of course, the potential for bankruptcy and financial distress are also greater.

Financial leverage is beneficial when the interest rate on the debt is less than the return on assets.

Financial leverage ratio = total liabilities / total equity.

Financial Leverage is different to the “Leverage Ratio” that you may come across when dealing with banks or financing institutions. This typically uses a debt-to-EBITDA ratio to measure a company’s ability to pay off its incurred debt with profits. The ratio determines how aggressive a company has been in financing its growth with debt, which links back into the overall Financial Leverage which looks at whether the cost of debt is more or less than the return on assets.

Operating leverage explained.

Operating leverage is a cost-accounting formula measuring the potential for a business to increase operating income by increasing revenue. It can be defined as the impact of a percentage change in sales on the percentage change in operating income, due to fixed operating expenses.

The more fixed costs a company has, the more sales it needs to generate to cover them, which introduces significantly more risk in the business. However, after covering fixed costs, each net new pound of revenue goes straight to profit. The potential upside for sales achieved over and above break even must be considered against the (usually sizable) amount of sales required to hit that point.

Operating leverage is beneficial when the company is operating above its breakeven point (sales – variable costs > fixed costs). The benefits of a company with high operating leverage can be significant, as there will be minimal additional cost for each additional unit of sales. However, these companies can also be highly exposed when sales slump and the company falls below its breakeven point.

Operating leverage ratio = fixed costs / total costs