Define operating leverage and financial leverage.

Define operating leverage and financial leverage.

• A. Operating leverage measures how EBIT responds to changes in sales due to fixed operating costs; financial leverage measures how net income or EPS responds to changes in EBIT due to fixed financing costs.
• B. Operating leverage measures how EBIT responds to changes in taxes; financial leverage measures how EBIT responds to changes in sales.
• C. Operating leverage measures how cash flows respond to changes in costs; financial leverage measures how dividends respond to sales.
• D. Operating leverage measures how net income responds to changes in sales; financial leverage measures how equity responds to changes in EBIT.

Answer: (A)

Operating leverage is about how much EBIT moves when sales change, due to fixed operating costs. If a company has a lot of fixed costs, a small rise in sales can push EBIT up by a larger percentage, and a drop in sales can push EBIT down just as sharply. That reflects operating risk tied to the cost structure of the business. Financial leverage adds another layer: fixed financing costs, like interest, mean that changes in EBIT flow through to net income (or earnings per share) with amplified effect. When there’s debt, a higher EBIT after interest leaves more left over for net income, so the bottom line becomes more sensitive to operating performance than it would be without debt. So the best definition separates these two effects: operating leverage is about EBIT reacting to sales changes because of fixed operating costs, while financial leverage is about net income (or EPS) reacting to EBIT changes because of fixed financing costs.

Operating leverage is about how much EBIT moves when sales change, due to fixed operating costs. If a company has a lot of fixed costs, a small rise in sales can push EBIT up by a larger percentage, and a drop in sales can push EBIT down just as sharply. That reflects operating risk tied to the cost structure of the business.

Financial leverage adds another layer: fixed financing costs, like interest, mean that changes in EBIT flow through to net income (or earnings per share) with amplified effect. When there’s debt, a higher EBIT after interest leaves more left over for net income, so the bottom line becomes more sensitive to operating performance than it would be without debt.

So the best definition separates these two effects: operating leverage is about EBIT reacting to sales changes because of fixed operating costs, while financial leverage is about net income (or EPS) reacting to EBIT changes because of fixed financing costs.