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In finance, the term leverage arises often. Both investors and companies employ
leverage to generate greater returns on their assets. However, using leverage
does not guarantee success, and the possibility of excessive losses is greatly
enhanced in highly leveraged positions. For companies, there are two types of
leverage that can be used: operating leverage and financial leverage.
Operating leverage relates to the result of different combinations of fixed
costs and variable costs. Specifically, the ratio of fixed and variable costs
that a company uses determines the amount of operating leverage employed. A
company with a greater ratio of fixed to variable costs is said to be using
more operating leverage. If a company's variable costs are higher than its
fixed costs, the company is said to be using less operating leverage. The way
that a business makes sales is also a factor in how much leverage it employs. A
firm with few sales and high margins is said to be highly leveraged. On the
other hand, a firm with a high volume of sales and lower margins is said to be
less leveraged.
Financial leverage arises when a firm decides to finance a majority of its
assets by taking on debt. Firms do this when they are unable to raise enough
capital by issuing shares in the market to meet their business needs. When a
firm takes on debt, it becomes a liability on which it must pay interest. A
company will only take on significant amounts of debt when it believes that
return on assets (ROA) will be higher than the interest on the loan.
A firm that operates with both high operating and financial leverage makes for
a risky investment. A high operating leverage means that a firm is making few
sales but with high margins. This can pose significant risks if a firm
incorrectly forecasts future sales. If a future sales forecast is slightly
higher than what actually occurs, this could lead to a huge difference between
actual and budgeted cash flow, which will greatly affect a firm's future
operating ability. The biggest risk that arises from high financial leverage
occurs when a company's ROA does not exceed the interest on the loan, which
greatly diminishes a company's return on equity and profitability.
To learn more, see Introduction To Fundamental Analysis, Understanding The
Subtleties Of ROA Vs. ROE and When Companies Borrow Money.