Compare Financial and Operational Leverage.
What is Financial and Operational Leverage? What is the difference between the two and what are the affects ofn organizational performance when depending on these types of Leverage.
Financial leverage can be a good thing for a company or it can also be a bad thing. The exact definition is the degree to which an investor or business utilizes borrowed money. “If a company has a high financial leverage they may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to obtain future lenders.” If the Financial responsibility is not too high, it can increase the shareholders’ returns on their investments. There may also be tax advantages connected to this type of Leverage.
Operational Leverage is the use of the percent of a company’s fixed cost in the company’s cost structure. Usually, the higher the operating leverage, the more a company's income is affected by movement in the sales volume. When the higher income is compared to the sales ratio and the results are a smaller portion of the costs, this means the company does not have to pay as much additional money for each unit produced or sold. The higher the production and sales become, the more beneficial the investment in the fixed costs. This encompasses operational expenses connected with “advertising expenses, administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt, which is part of financial leverage.”
Both types of leverage can be a risk to the company, but the risk can be big rewards for the company and stockholders if the cost is managed and a company does not over leverage.