Financial and Operating Leverage - 2

In previous blog, we discussed Financial Leverage. And now, let’s talk about Operating Leverage.

Financial Leverage is to do with the Capital Structure of a firm, where as Operating Leverage is how that capital has been invested in the firm for its operations.

We know ‘Production Costs’ are broadly categorized as ‘Fixed Costs’ and ‘Variable Costs’. If a firm invests heavily in its PP&E (Property, Plant and Equipment), that is, in its fixed assets, it is increasing its ‘Fixed Costs’. Motivation for doing that is to be able to reduce ‘Variable Costs’.

Now, increase in ‘Fixed Costs’ gives firm the leverage to increase its sales and get magnified returns as compared to its competitors. Let’s see this with an example:

Example

There are 2 firms A and B. Firm A has invested heavily in its Fixed Assets and has higher Fixed Costs and lower Variable Costs as compared to another Firm B, in the same industry. Firm A has higher Operating Leverage as compared to Firm B.

Say, it is boom time and sales for both firms are 500 units each. Both have same Sales and sell at the same price. Yet, Firm A has higher Earnings than Firm B!!

-

This is the magic of Operating Leverage working on Firm A’s side!!

Now the Risk Side

Again, we know higher returns are always associated with higher Risks. So what are the risks here?

Let’s go back to our example. Now, say, it is a slack time and sales for both firms have fallen to just 10 units. As seen in the figure below, Firm A with higher Operating Leverage is now making losses, whereas Form B is still showing positive earnings!
-

Analysis
Other things same, with higher Operating Leverage, your point of breakeven sales would be higher as compared to a firm with lower Operating Leverage. For sales higher than the breakeven point, your gains will be higher. And for sales lower than the breakeven point your losses will be higher.

Financial And Operating Leverage - 1

In most financial reading material, you come across the term ‘leverage’ multiple limes. In this blog, I will attempt to create an understanding of what it means.

-

In your early school years, you would have studied ‘levers’ in physics or mechanics. You already know, how using a lever, you can get multiplied power, which you would not have otherwise.

-

In Finance it is a similar concept.

-

Let me explain that with examples.

-

Financial Leverage

• Let’s say you have a Business Project, which is estimated to give you a 15% return in 1 year.
• It requires an investment of $100.
• But adding up all your money, you only have $10 of your own money (equity).
• Remaining $90 (debt), you are able to borrow from the market at say 5%.
• After 1 year, as estimated, your project completed and returned $115.
• From this you pay back $90 principal plus $4.5 interest.
• Remaining amount left with you is $20.5 .
• That is, you got $20.5 on your investment of $10. Which is a hefty 105% return on your equity!
• Meaning, though your project returned only 15%, you actually got 105% return on your equity, ex all your debt obligations!!!

This is the magic of Financial Leverage. Other things same, higher your debt with respect to your equity, higher is the leverage and higher would be the return on your equity. But not so soon :)

-

The Risk Side

-

This higher return comes with equally higher risk. In Finance, always expect higher returns to be associated with higher risks. Let’s see how!

• Now, let’s say for your previous project, instead of 15% profit, it returned 15% loss So, after 1 year, you are left with $85.
• And you owe $94.5 to your creditors (90 + 4.5).
• You pay all of $85 you have and still owe them $9.5 .
• Your equity of $10 is all wiped out and you are filing bankruptcy as you cannot pay your remaining $9.5 obligation.

That is the Risk side of Leverage. Investors take high leverage companies as risky, so cost of their equities is higher.

-

To analyze this mathematically:

• If project returns are more than the interest rate you pay on your debt, your net GAINS will be magnified by the leverage.
• But if your project returns are lower than your loan interest rate, your net LOSSES will be magnified by the leverage.

I will discuss Operating Leverage in the next blog.