What is Financial and Operational Leverage?

What is Leverage?

Leverage is a strategy in which capital is borrowed from third parties, or other financial instruments, to increase the potential return on an investment.

By taking external capital, a company can carry out its leverage process at a time that is growing and making profits, but is running out of its own resources to continue its expansion.

As it involves an amount external to the company, leverage operations entail new fixed costs and, consequently, new risks for activities.

Leverage can be carried out on different proportions of the company’s capital, so two different types of leverage are considered: Financial and Operational.

What is Financial Leverage?

Financial leverage is measured by the company’s ability to increase profit by increasing fixed costs through this process.

This means of leverage is associated with the level of indebtedness involved in the business, together with the percentage increase in net profit that goes to the partners or shareholders.

Thus, the concept of financial leverage relates the capital that the company takes from third parties to “leverage” earnings per share, as the equity of the business, if the operation is successful.

How to Calculate the Degree of Financial Leverage (GAF)

To carry out this operation, it is possible to analyze the effect of indebtedness and interest remuneration, on the borrowed capital, with the net profit that the company can achieve.

With this, the earnings before and after interest payments, used in the formula, are used in the calculation:

GAF = LAJIR ÷ LAIR

LAJIR: Earnings before interest and income tax (in English EBITDA)
LAIR: Earnings before income tax or LAJIR minus Interest (in English EBIT)

For a result greater than 1, it means that the additional profit offered to shareholders is greater than the remuneration for the loan made. With a degree less than or equal to 1, the operation was not successful.

Example of financial leverage

A company searched for capital from a third party that paid interest in the amount of US $ 5,000.00 in a period in which LAJIR reached the amount of US $ 12,000.00.

To calculate your GAF, the value of the LAIR is used, which in this case has the value of US $ 7,000.00 (12,000 – 5,000):

GAF = 12,000 / 7,000
GAF = 1,71

As the value is greater than one, the company’s financial leverage was successful and returns an additional profit to the partners or shareholders.

What is Operational Leverage?

Operational leverage occurs when the resource used does not increase the firm’s fixed costs, and the quantity produced can be increasing in order to “move away” from this cost.

In this type of strategy, it is common, for example, to purchase machinery or other assets that make it possible to increase production and sales at a level where revenues are higher than fixed and variable costs.

How to Calculate the Operational Leverage Degree (GAO)

This measure makes it possible to understand the intensity that the leverage strategy appears in the business’s operating result.

A formula to understand the GAO is to calculate, through the Statement of Income for the Year (DRE), the values ​​for the contribution margin and the EARNINGS:

GAO = MC ÷ LAJIR

MC: Contribution margin, which can be calculated as = Revenue – Variable Costs
EARNINGS: Earnings before interest and income tax (in English EBITDA)

There is also another formula that uses the variations in sales with leverage, and that can be more useful for entrepreneurs who do not prepare the DRE:

GAO = change in operating profit (%) ÷ change in sales volume (%)

The indication of a very high GAO may mean that the business is close to its break-even point, where revenue may be high, but at even higher fixed and variable costs.

GAO can also have a negative value when there is an increase in revenue, but causing a drop in operating income, or when the contribution margin is negative.

Example of operational leverage

Before acquiring new resources through credit, a company had an operating profit of US $ 8,000.00 while its sales volume reached US $ 20,000.00.

After acquiring new resources, the sales volume increased to US $ 30,000.00, but the operating profit decreased to US $ 5,000.00, in which the GAO can be calculated from the variations in profit and sales:

Variation in operating profit: (5,000 – 8,000) / 5000 = -0,6 (-60%)
Variation in sales: (30,000 – 20,000) / 30,000 = 0.3 (3) (33.34%)

GAO = -0.6 ÷ 0.3 (3)
GAO = -1.8

The negative value is probably a result of the increase in operating costs and expenses caused by the unsuccessful leverage.

Differences between Financial and Operational Leverage

One of the main differences is the use, for the calculation, of fixed costs through operating leverage and that of fixed financial charges when we speak of financial leverage.

The risks for each type of leverage are differentiated by the resources that are used, since the operational one involves commercial risks and the financial one involves risks regarding the credit taken.