• Business
  • Finance
  • Banking
  • Education
  • General
  • Law
  • Science
  • IT
  • English

Key Differences

Know the Differences & Comparisons

Difference Between Operating Leverage and Financial Leverage

Last updated on July 26, 2018 by Surbhi S

LeverageIn general, leverage means affect of one variable over another. In financial management, leverage is not much different, it means change in one element, results in change in profit. It implies, making use of such asset or source of funds like debentures for which the company has to pay fixed cost or financial charges, to get more return. There are three measures of Leverage i.e. operating leverage, financial leverage, and combined leverage. The operating leverage measures the effect of fixed cost whereas the financial leverage evaluates the effect of interest expenses.

Combined Leverage is the combination of the two leverages. While operating leverage delineates the effect of change in sales on the company’s operating earning, financial leverage reflects the change in EBIT on EPS level. Check out the article given below to understand the difference between operating leverage and financial leverage.

Content: Operating Leverage Vs Financial Leverage

  1. Comparison Chart
  2. Definition
  3. Key Differences
  4. Conclusion

Comparison Chart

Basis for ComparisonOperating LeverageFinancial Leverage
MeaningUse of such assets in the company's operations for which it has to pay fixed costs is known as Operating Leverage.Use of debt in a company's capital structure for which it has to pay interest expenses is known as Financial Leverage.
MeasuresEffect of Fixed operating costs.Effect of Interest expenses
RelatesSales and EBITEBIT and EPS
Ascertained byCompany's Cost StructureCompany's Capital Structure
PreferableLowHigh, only when ROCE is higher
FormulaDOL = Contribution / EBITDFL = EBIT / EBT
RiskIt give rise to business risk.It give rise to financial risk.

Definition of Operating Leverage

When a firm utilizes fixed cost bearing assets, in its operational activities in order to earn more revenue to cover its total costs is known as Operating Leverage. The Degree of Operating Leverage (DOL) is used to measure the effect on Earning before interest and tax (EBIT) due to the change in Sales.

The firm, which employs high fixed cost and the low variable cost is regarded as high operating leverage whereas the company which has low fixed cost, and the high variable cost is said to have less operating leverage. It is fully based on fixed cost. So, the higher the fixed cost of the company the higher will be the Break Even Point (BEP). In this way, the Margin of Safety and Profits of the company will be low which reflects that the business risk is higher. Therefore, low DOL is preferred because it leads to low business risk.

The following formula is used to calculate Degree of Operating Leverage (DOL):

Operating Leverage

Definition of Financial Leverage

The utilization of such sources of funds which carry fixed financial charges in company’s financial structure, to earn more return on investment is known as Financial Leverage. The Degree of Financial Leverage (DFL) is used to measure the effect on Earning Per Share (EPS) due to the change in firms operating profit i.e. EBIT.

When a company uses debt funds in its capital structure having fixed financial charges in the form of interest, it is said that the firm employed financial leverage.

The DFL is based on interest and financial charges, if these costs are higher DFL will also be higher which will ultimately give rise to the financial risk of the company. If Return on Capital Employed > Return on debt, then the use of debt financing will be justified because, in this case, the DFL will be considered favorable for the company. As the interest remains constant, a little increase in the EBIT of the company will lead to a higher increase in the earnings of the shareholders which is determined by the financial leverage. Hence, high DFL is suitable.

The following formula is used to calculate Degree of Financial Leverage (DFL):

financial leverage

Key Differences Between Operating Leverage and Financial Leverage

The following are the major differences between operating leverage and financial leverage:

  1. Employment of fixed cost bearing assets in the company’s operations is known as Operating Leverage. Employment of fixed financial charges bearing funds in a company’s capital structure is known as Financial Leverage.
  2. The Operating Leverage measures the effect of fixed operating costs, whereas Financial Leverage measures the effect of interest expenses.
  3. Operating Leverage influences Sales and EBIT but Financial Leverage affects EBIT and EPS.
  4. Operating Leverage arises due to the company’s cost structure. Conversely, the capital structure of the company is responsible for Financial Leverage.
  5. Low operating leverage is preferred because higher DOL will cause high BEP and low profits. On the other hand, High DFL is best because a slight rise in EBIT will cause a greater rise in shareholder earnings, only when the ROCE is greater than the after-tax cost of debt.
  6. Operating Leverage creates business risk while Financial Leverage is the reason for financial risk.

Conclusion

While the performance of financial analysis, Leverage, is used to measure the risk-return relation for alternative capital structure plans. It magnifies the changes in financial variables like sales, costs, EBIT, EBT, EPS, etc. The firms which use debt content in its capital structure are regarded as Levered Firms, but the company with no debt content in its capital structure is known as Unlevered firms. The multiplication of DOL and DFL will make DCL i.e. Degree of Combined Leverage.

Related Differences

  • Difference Between Substitute Goods and Complementary Goods
  • Difference Between Bookkeeping and Accounting
  • Difference Between Pledge and Hypothecation
  • Difference Between SIP and Mutual Fund
  • Difference Between Whole Life and Term Life Insurance

You Might Also Like:

Capital Structure Vs financial structureDifference Between Capital Structure and Financial Structure Business Risk vs Financial RiskDifference Between Business Risk and Financial Risk leaseDifference Between Finance (Capital) Lease and Operating Lease Difference Between Gross, Operating and Net Profit Difference Between EBIT and EBITDA Difference Between Debt and Equity

Comments

  1. golam rabbani rahman says

    November 19, 2019 at 11:56 pm

    Thanks, Ma’am. you’re doing a great job, I am enjoying to read your articles, it’s very simple and suitable to understanding.

    Reply
  2. Maria says

    March 29, 2022 at 1:17 pm

    Dear
    Nice post! This is a very nice blog.

    Reply

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Top 5 Differences

  • Difference Between PERT and CPM
  • Difference Between Micro and Macro Economics
  • Difference Between Developed Countries and Developing Countries
  • Difference Between Management and Administration
  • Difference Between Qualitative and Quantitative Research

Related Differences

  • Difference Between Substitute Goods and Complementary Goods
  • Difference Between Bookkeeping and Accounting
  • Difference Between Pledge and Hypothecation
  • Difference Between SIP and Mutual Fund
  • Difference Between Whole Life and Term Life Insurance



New Additions

  • Difference Between Speak and Talk
  • Difference Between Economy Class and Business Class
  • Difference Between If and Whether
  • Difference Between Hotel and Motel
  • Difference Between FIR and Chargesheet
  • Difference Between Norms and Values
  • Difference Between Society and Community
  • Difference Between Sourcing and Procurement
  • Difference Between National Income and Per Capita Income
  • Difference Between Departmental Store and Multiple Shops
fb-follow youtube follow

Copyright © 2023 · Key Differences · Contact Us · About Us · Privacy