Leverage Analysis: Financial, Operating, and Combined Leverage

Leverage analysis refers to the examination of a company’s financial structure and its impact on the company’s profitability and risk. There are three types of leverage that can be analyzed: financial leverage, operating leverage, and combined leverage.

Financial Leverage:

Financial leverage measures the extent to which a company uses debt financing in its capital structure. Financial leverage increases the potential returns to shareholders, but it also increases the risk of financial distress or bankruptcy. The primary measure of financial leverage is the debt-to-equity ratio, which measures the amount of debt a company has relative to its equity capital.

Operating Leverage:

Operating leverage measures the fixed costs a company has in its operations, such as rent, salaries, and depreciation. A company with high fixed costs has high operating leverage, which means that its profits will increase rapidly when sales increase, but will also decrease rapidly when sales decrease. The primary measure of operating leverage is the contribution margin, which is the difference between a company’s revenue and its variable costs.

Combined Leverage:

Combined leverage is the combination of financial leverage and operating leverage. It measures the effect of changes in sales on a company’s earnings per share (EPS). Combined leverage can be calculated by multiplying a company’s financial leverage ratio by its operating leverage ratio.

The analysis of leverage can help investors and analysts understand the risks and potential returns of a company’s financial structure. A company with high financial leverage may be more vulnerable to changes in interest rates or market conditions, while a company with high operating leverage may be more vulnerable to changes in sales or pricing. Additionally, a company with high combined leverage may have a high potential for earnings growth but also a high risk of volatility in earnings.