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LEVERAGE

Operating leverage measures how a firm's operating income can increase with revenue, with high leverage indicating greater profitability after covering fixed costs, while low leverage limits profit potential due to variable costs. High operating leverage can be beneficial in revenue growth but detrimental during declines, as fixed costs remain constant. Financial leverage involves using debt to enhance returns on equity, but excessive leverage increases the risk of financial failure.

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19 views14 pages

LEVERAGE

Operating leverage measures how a firm's operating income can increase with revenue, with high leverage indicating greater profitability after covering fixed costs, while low leverage limits profit potential due to variable costs. High operating leverage can be beneficial in revenue growth but detrimental during declines, as fixed costs remain constant. Financial leverage involves using debt to enhance returns on equity, but excessive leverage increases the risk of financial failure.

Uploaded by

mehnaz k
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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LEVERAGE

COST ACCOUNTING
INSTRUCTOR: MEHNAZ KHAN
Operating leverage is a cost-accounting formula that measures the
degree to which a firm or project can increase operating income
by increasing revenue. A business that generates sales with a high
gross margin and low variable costs has high operating leverage.
•If a company has high operating leverage, each additional
dollar of revenue can potentially be brought in at higher
profits after the break-even point has been exceeded. Thus,
each marginal unit is sold at a lesser cost, creating the potential for
greater profitability since fixed costs such as rent and utilities remain
the same regardless of output.
•If a company has low operating leverage (i.e., greater
variable costs), each additional dollar of revenue
can potentially generate less profit as costs increase in
proportion to the increased revenue. Here, as more revenue is
produced, the growth in the variable costs offsets the additional
revenue and limits the company’s capacity to endure periods of
lackluster sales performance (i.e., sustain its profit margins to stay in
line with historical levels).
When a company’s revenue increases, having a high degree of
leverage tends to be beneficial to its profit margins

However, if revenue declines, the leverage can end up being


detrimental to the margins of the company because the
company is restricted in its ability to implement potential cost-
cutting measures.
In a high operating leverage situation, a large proportion of
the company’s costs are fixed costs. In this case, the firm
earns a large profit on each incremental sale, but must attain
sufficient sales volume to cover its substantial fixed costs. If
it can do so, then the entity will earn a major profit on all
sales after it has paid for its fixed costs. However, earnings
will be more sensitive to changes in sales volume.

In a low operating leverage situation, a large proportion of


the company’s sales are variable costs, so it only incurs
these costs when there is a sale. In this case, the firm earns
a smaller profit on each incremental sale, but does not have
to generate much sales volume in order to cover its lower
fixed costs. It is easier for this type of company to earn a
profit at low sales levels, but it does not earn outsized profits
FINANCIAL LEVERAGE

Financial leverage is the use of debt to buy more assets. Leverage is


employed to increase the return on equity. However, an excessive amount
of financial leverage increases the risk of failure, since it becomes more
difficult to repay debt.

A degree of financial leverage (DFL) is a leverage ratio that measures the


sensitivity of a company's earnings per share (EPS) to fluctuations in its
operating income, as a result of changes in its capital structure.

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