Operating and Financial Leverage^77
One of the most important of the various financial decisions is how much leverage a
firm should employ.
A fundamental decision made by any business is the degree to which it incurs fixed
costs. A fixed cost is one that remains the same regardless of the level of operations.
As sales increase, fixed costs don't increase in the same proportion. Some fixed costs
do not increase at all till a particular point. As a result, profits can rise faster during
good times. On the other hand, during bad times fixed costs don't decline, so profits fall
more rapidly than sales do.
The degree to which a firm locks itself into fixed costs is referred to as its leverage
position. The more highly leveraged a firm, the riskier it is because of the obligations
related to fixed costs that must be met whether the firm is having a good year or not. At
the same time, the more highly leveraged the greater the profits during good times. This
presents a classic problem of making a decision where there is a trade-off between risk
and return.
There are two major types of leverage - financial and operating. Financial leverage is
specifically the extent to which a firm gets its cash resources from borrowing (debt) as
opposed to issuance of additional shares of (equity). The greater the debt compared to
equity, the more highly leveraged the firm because debt legally obligates the firm to
interest payments. These interest payments represent a fixed cost.
Operating leverage is concerned with the extent to which a firm commits itself to high
levels of fixed costs other than interest payments. A firm that rents property using
cancellable leases has less leverage than a firm that commits itself to a long-term
noncancellable lease does. A firm that has substantial vertical integration has created a
highly leveraged situation. Consider what happens if a company vertically integrates by
acquiring its raw materials' supplier. Raw materials will now cost the company less,
because it doesn't have to buy them from an outside firm. But when times are bad, the
firm will have to bear the fixed costs associated with the supplier subsidiary. Had there
still been two separate companies, the big company could have simply slowed its
purchases of raw materials from supplier without having to bear its fixed costs.
In the cases of both financial and operating leverage, the crucial question is how much
leverage is appropriate. We can't answer that question in absolute terms, but we will
Chapter-3
Operating and Financial Leverage