Financial and operating 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 when it is growing and making profits, but is running out of its own resources to continue its expansion.

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

Leverage can be carried out in different proportions of the company’s capital, so two different types of leverage are considered: financial and operational.

What is leverage?

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

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

Therefore, the concept of financial leverage relates the capital that the company takes from third parties to “leverage” the earnings per share, such 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 Taxes and Income (  EBITDA  )
LAIR: Earnings Before Taxes or LAJIR Less Interest (  EBIT  )

For a result greater than 1, it means that the additional benefit offered to the shareholders is greater than the remuneration for the loan made. With a grade less than or equal to 1, the operation was unsuccessful.

Example of financial leverage

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

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

GAF = 12,000 / 7,000
GAF = 1.71

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

What is operating leverage?

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

In this type of strategy, it is common, for example, to buy machinery or other assets that allow to increase production and sales to a level where income is higher than fixed and variable costs.

How to calculate the degree of operating leverage (GAO)

This measure allows us to understand the intensity with which the leverage strategy appears in the operating result of the business.

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

GAO = MC ÷ LAJIR

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

There is also another formula that uses variations in leveraged sales, which may 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 breakeven, where revenues 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 it causes a drop in operating income, or when the contribution margin is negative.

Example of operating leverage

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

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

Variation in operating income: (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 likely the result of the increase in operating costs and expenses caused by the failed leverage.

Differences between financial and operating leverage

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

The risks for each type of leverage are differentiated by the resources used, since the operating one involves commercial risks and the financial one involves risks related to the credit taken.

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