Leverage in its most general sense means the ability to magnify results at a relatively low cost. In business, you make decisions about leverage that affect your profitability.

When you evaluate whether you can increase production profitably, you are addressing operating leverage. If you are contemplating taking on additional debt, you have entered the realm of financial leverage. It’s important to be able to distinguish between operating and financial leverage for making important business decisions.

Understanding Operating Leverage

Operating leverage compares sales to the costs of production. Fixed costs involve the property, plant and equipment you use to create products. These costs are independent of the number of units you produce. Variable costs are the additional costs required to produce a unit of marketable inventory, such as the costs of raw materials, electricity, packaging and transportation.

When comparing operating leverage vs financial leverage, know you can measure operating leverage as the ratio of fixed costs to variable costs or fixed costs to total costs, explains the Corporate Finance Institute. Higher values of this ratio indicate high operating leverage.

Examining Effects of Operating Leverage

A high operating leverage means you are in a position to increase production without investing in additional fixed costs. As production rises, you are in effect spreading fixed costs across a greater number of units, so the additional units have a lower ratio of fixed costs to total costs. The degree of operating leverage – the percent change in earnings before interest and taxes, or EBIT, divided by the percentage change in sales – gives you a means to gauge how earnings will respond to sales activity.

When demand for your product increases, you can easily ramp up production by increasing variable costs; your fixed assets allow you to magnify production. You can increase production as long as your higher variable costs don’t cause total costs to exceed your sales revenues. However, in a recession, high operating leverage is risky, as it saddles you with high fixed costs even when you cut production.

Exploring Financial Leverage

According to AccountingTools, financial leverage is a measure of debt, usually defined as total debt divided by the owners’ equity, which is assets minus liabilities. By increasing financial leverage instead of issuing stock, you can use the additional funds to increase production without diluting earnings among a greater number of shareholders.

In this sense, it magnifies your profits per share. You can measure this effect with the formula for degree of financial leverage: EBIT divided by earnings before taxes.

However, additional leverage increases your interest expense, which cuts into net income, even though interest is tax deductible. If you are overleveraged and sales fall, you might find yourself short of cash and face default on your debt.

Calculating Your Combined Leverage

Now that you understand the difference between operating leverage and financial leverage, you should know how to find your company’s combined leverage. The degree of combined, or total, leverage is defined as the percentage change in earnings per share divided by the percentage change in sales.

It is the product of the degree of financial leverage and the degree of operating leverage. As such, it is a measure of the overall riskiness of your business.

A high combined leverage indicates high fixed costs and heavy debt. In good times, these factors can increase profits as you increase sales. Should business falter, these same factors mean you cannot cut total costs substantially by decreasing production, putting a strain on cash flow and your ability to pay interest and repay debt.