Distinguish between operating leverage and financial leverage. Give detailed examples for each.
Financial Leverage can be defined as the degree to which an investor or business is utilizing borrowed money as compared to the equity to fund its operatons.
The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky (volatile) a company's operating income is.
Both operating and financial leverage result in the magnification of changes to earnings due to the presence of fixed costs in a company's cost structure. The difference is only the part of the income statement we are looking at. Operating leverage is the magnification on the top half of the income statement¾how EBIT changes in response to changes in sales; the relevant fixed cost is the fixed cost of operating the business. Financial leverage is the magnification on the bottom half of the income statement¾how earnings per share changes in response to changes in EBIT; the relevant fixed cost is the fixed cost of financing, in particular interest.
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