MEANING OF OPERATING AND FINANCIAL LEVERAGE

Operating leverage occurs any time a firm has fixed cost that must be met regardless of volume. operating leverage is the technique of magnifying the EBIT by using fixed costs that must be met regardless of volume in the capital structure. An entrepreneur generally employ assets with a fixed cost in the hope that volume will produce revenues more than sufficient to cover all fixed and variable costs. For example in an airline industry, a large portion of total cost are fixed. Beyond the break-even point each additional passenger represents essentially straight profit to the airline. So is the case of a bus or railway and so on. With fixed costs, the percentage change in profit accompanying a change in volume is greater than the percentage change in volume. This occurace is known as operating leverage. Operating leverage can be explained better by means of break-even or cost-volume-profit analysis.

Financial Leverage may be defined as the use of fixed financial charges in the firm’s capital structure to magnify the Earning Per Share. Financial leverage occurs when funds with charges, such as debt and preference share are used with the owner’s equity in the capital structure. The financial leverage is employed by a company with an intention to earn more on fixed charges funds than their costs. It amy be compared to a fulcrum used in physics in the sense that the surplus over interest cost will be used as a lever or fulcrum to increase the return on the owner’s equity which is projected by an increase in the EPS. For example, if a company borrows tk. 100 at 10 per cent interest. This is also termed as ‘trading on the equity’ in the sense that here the owner’s equity is used as a basis to raise debt.

Distinction between Operating Leverage and Financial Leverage

|Points of Differences |Operating