Types of Leverage: Financial, Operating and Combined

Got a fantastic business opportunity but no cash in your bank account? You need to leverage your assets to gain capital.

Leverage is a tool businesses frequently use to increase inventory, purchase equipment, or grow their assets. And you can use it to finance your next big acquisition—be it a new computer, factory, or venture.

However, while leverage is a great source of funding and can increase the rate of return on equity, it also magnifies risk. A business that lacks sufficient cash flow will be unable to meet interest rates and principal payments. So, you’ll want to understand the types of leverage you have on your balance sheet to evaluate expected risks and returns and avoid losses.

This article explores what leverage is, how it works, and the types of leverage you can choose to increase your potential returns.

• What is leverage?
• Financial leverage
• Operating leverage
• Combined leverage
• Leverage disadvantages
• Tools and resources for managing leverage
• Introduction to leverage ratios
• Leverage in personal finance

What is leverage?

Leverage refers to borrowing funds for a particular purpose with an obligation to repay these funds, with interest, according to an agreed schedule. The idea behind leverage is to help borrowers achieve a higher return with a smaller investment.

You’ll want to forecast your expenditures and determine your funding requirements before deciding what kind of leverage to use. Instruments like derivatives, where the investment is a small fraction of the underlying position, can be used as leverage. However, in this article, we focus on debt.

Examples of leverage in business

Let’s explore some practical examples of how businesses use leverage to fuel growth and maximize returns in various industries:

• Real estate development. A property developer borrows $800,000 to purchase a $1 million property, using $200,000 of their own capital. If the property value increases by 10% to $1.1 million, the developer’s equity grows to $300,000, representing a 50% return on their initial investment.
• Startup expansion. A tech startup secures a $500,000 loan to develop a new product. The product becomes successful, generating $2 million in revenue. The company repays the loan and keeps the remaining profits, achieving significant growth with limited initial capital.
• Retail inventory financing. A small retailer uses a $50,000 line of credit to purchase inventory for the holiday season. This allows them to stock up on popular items and increase sales by 30%, generating enough profit to easily repay the loan and boost overall revenue.
• Manufacturing equipment purchase. A manufacturer borrows $1 million to buy new, more efficient machinery. The new equipment increases production capacity by 40% and reduces operating costs by 20%, allowing the company to repay the loan quickly and improve long-term profitability.
• Corporate acquisition. A large corporation uses $500 million in borrowed funds to acquire a competitor for $700 million. The acquisition leads to increased market share, cost synergies, and a 25% boost in overall revenue, justifying the use of leverage.

These examples illustrate how businesses can use leverage to expand operations, increase profits, and achieve growth that might not be possible with only their existing capital. However, it’s crucial to carefully consider the risks and potential returns before taking on debt.

How does leverage work?

If and when your business is ready to increase its scale of operations, expand into new markets, or update existing infrastructure, you’re going to need funds. However, if you don’t have enough equity or cash upfront, you’ll have to borrow funds.

Two ways to borrow capital are to issue bonds (equity financing) or borrow directly from lenders (debt financing).

Equity financing involves selling your equity in exchange for funding. One of the biggest benefits of equity financing is that it doesn’t lead to the company having to make interest payments or any principal repayment. Some of the most common examples of equity financing are:

• Initial public offerings (IPOs). Example: Facebook went public in 2012, raising $16 billion.
• Crowdfunding. Example: Oculus VR raised $2.4 million on Kickstarter in 2012.
• Venture capital. Example: Uber raised $258 million from Google Ventures and TPG in 2013.

Debt financing involves a company borrowing money to fund working capital requirements. When a company borrows money, it needs to make interest payments as well as repay the principal. Common debt financing examples include:

1. Bank loans. Example: A manufacturing company taking out a $10 million term loan to upgrade facilities.
2. Corporate bonds. Example: Apple issuing $17 billion in bonds in 2013 for a stock buyback program.
3. Lines of credit. Example: A retail chain securing a $50 million revolving credit facility for inventory management.

The use of leverage varies across different business contexts:

• Small businesses often rely on bank loans, equipment financing, or SBA (Small Business Association) loans. For instance, a local restaurant might borrow $50,000 to renovate its dining area.
• Medium-sized enterprises might use larger bank loans or mezzanine financing (combining debt and equity)  for expansion. A regional fitness center chain could secure a $2 million loan to open new locations.
• Large corporations can access corporate bonds and syndicated loans for major strategic moves. A multinational tech company might issue $5 billion in bonds to fund R&D for a new product line.

When considering leverage, businesses must carefully weigh the potential benefits against the risks and costs associated with taking on debt or diluting ownership through equity financing.

There are three main types of leverage: financial, operating, and combined. We explain each in more detail below.

Financial leverage

Financial leverage refers to the amount of debt a business has acquired. On a balance sheet, financial leverage relates to the liabilities listed on the right-hand side of the sheet.

Using financial leverage allows your business to continue making investments even if it’s short on cash. This is often preferred to equity financing, as it allows you to raise funds without diluting your ownership.

Financial leverage can significantly benefit businesses by:

• Amplifying returns. When investments financed by debt yield higher returns than the cost of borrowing, the company’s overall profitability increases.
• Tax advantages. Interest payments on debt are often tax deductible, reducing the effective cost of borrowing.
• Maintaining control. Unlike equity financing, debt doesn’t require giving up ownership or decision-making power.
• Flexibility. Various debt instruments offer different terms and conditions to suit specific business needs.

However, financial leverage also comes with risks, primarily the obligation to repay debt regardless of business performance.

Below are some examples of companies successfully using financial leverage:

• Apple Inc. Despite having large cash reserves, Apple has strategically used debt to fund share buybacks and dividends. In 2013, they issued $17 billion in bonds, taking advantage of low interest rates to enhance shareholder value.
• McDonald’s Corporation. The company has used leverage to fund global expansion and franchisee support. Their debt-to-equity ratio often exceeds 100%, yet they maintain strong credit ratings due to consistent cash flows.
• Tesla Inc. In its early years, Tesla heavily relied on debt financing to fund research, development, and production scaling. This strategy allowed them to become a leader in the electric vehicle market while preserving equity for early investors.

When considering financial leverage, businesses must carefully assess their ability to service debt and the potential return on investments funded by borrowed capital. The optimal level of leverage varies by industry and company-specific factors.

How to calculate financial leverage

You can determine the degree of financial leverage your business has through the debt-to-equity ratio. This ratio represents the proportion of assets your business has compared to its shareholders’ equity.

The formula is:

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Let’s assume your total assets for the current year are $100,000, and for the previous year, they were $90,000. Your average total assets would then be:

(100,000 + 90,000)/2 = $95,000

You can calculate average total equity the same way.

So,

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A financial leverage ratio of 1 indicates no leverage. The higher the ratio, the more leveraged your business is and the riskier your capital structure.

Operating leverage

Operating leverage accounts for the fixed operating costs and variable costs of providing goods and services. As fixed assets don’t change with the level of output produced, their costs are constant and must be paid regardless of whether your business is making a profit or experiencing losses. On the other hand, variable costs change depending on the output produced.

You can determine operating leverage by finding the ratio of fixed costs to variable costs. If your business has more fixed expenses than variable expenses, it has high operating leverage. You can use a high degree of operating leverage to magnify your returns, but too much of it can increase your financial risk.

Operating leverage affects business operations in several key ways:

• Profit sensitivity. High operating leverage amplifies the effect of sales changes on profits.
• Break-even point. Businesses with high fixed costs typically have higher break-even points (when revenues equal costs).
• Scalability. Once fixed costs are covered, additional sales can lead to higher profit margins.

These hypothetical case studies illustrate high vs. low operating leverage:

High operating leverage

A software company invests heavily in development (high fixed costs) but has low per-user costs (low variable costs). A 20% increase in subscribers might lead to a 50% increase in profits.

Low operating leverage

A retail store has low fixed costs (rent, basic staffing) but high variable costs (inventory). A 20% increase in sales could lead to a 15% increase in profits.

These scenarios demonstrate how operating leverage can significantly impact a business’s profitability and risk profile.

How to calculate operational leverage

As mentioned, operating leverage is the ratio of an entity’s fixed costs to its variable costs. You can calculate this using the formula:

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Let’s look at the hypothetical accounts for Business A and Business B,

‍*Money earned from regular business activities, indicating its operational efficiency and profitability before considering financing costs and tax implications.

Business A and Business B have a similar income statement structure; the only difference is that Business A has higher fixed costs than Business B. This implies a higher degree of operating leverage for Business A.

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Therefore, Business A has higher operating leverage than Business B.

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When demand is high and sales increase, profits rise by a more significant percentage for Business A than Business B. The average cost per unit also decreases by a greater amount for Business A than for Business B.

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In contrast, when sales stagnate, Business A suffers more than Business B. Profits for Business A decline more than they do for Business B, and the average cost per unit rises for Business A more than it does for Business B.

Operating leverage can be used by businesses that have a large number of fixed assets. For example, capital-intensive companies, such as steel production, car manufacturing, and oil extraction, can leverage their fixed assets to reduce the average cost per unit and increase earnings before interest and tax (EBIT).

Combined leverage

Combined leverage accounts for your organization’s total business risks. As the name suggests, combined leverage aggregates the effects of operating and financial leverages to present a complete picture of your company’s financial health.

Capital-intensive businesses with expansion potential but insufficient levels of cash or equity can use combined leverage. To effectively use combined leverage though, be sure of your business’s future expenses and expected market conditions. High levels of combined risk can make returns susceptible to variable inputs, such as sales volumes.

The importance of combined leverage lies in its ability to:

• Provide a comprehensive view of a company’s risk profile
• Help in making informed decisions about expansion or investments
• Illustrate the potential impact of changes in sales on net income

Calculate combined leverage by multiplying the degree of operating leverage (DOL) and the degree of financial leverage (DFL). A high combined leverage indicates that a small change in sales can lead to a large change in earnings per share.

Below are some practical examples of how businesses use combined leverage:

• A car manufacturer uses expensive machinery (high operating leverage) and takes on debt to finance a new production line (financial leverage). This combined leverage allows them to potentially increase profits significantly if car sales rise but also exposes them to higher risk if sales decline.
• A software startup invests heavily in development (high fixed costs, thus high operating leverage) and also takes on venture capital funding (financial leverage). This strategy allows rapid growth and market penetration but increases vulnerability to market fluctuations.
• A property developer uses both high operating leverage (large upfront costs for land and construction) and financial leverage (mortgages and loans) to fund projects. This approach can lead to substantial profits in a booming market but significant losses in a downturn.

When using combined leverage, businesses must carefully balance the potential for higher returns against the increased risk. Regular monitoring of market conditions and financial ratios is crucial for managing the risks associated with high combined leverage.

Leverage disadvantages

Leverage can magnify returns with a smaller investment, and while many investors prefer it to equity financing, there’s no such thing as a free lunch. Too much financial leverage can drive up a business’s risks, including:

• Insolvency. The more your company uses total debt, the harder it is to pay back. Banks and other institutions often check your total leverage and financial ratios, such as debt-to-equity and interest coverage, before agreeing to lend to you. Having too much total debt could have a risky cost structure, and you could have difficulty raising additional funds.
• Higher interest payments. Long-term debt can eat into a company’s bottom line because interest is paid from income. Also, the riskier your business seems to lenders, the higher your interest expense and resulting cost of capital.
• Liquidation. Your business can lose assets or eventually declare bankruptcy if it repeatedly defaults on payments. Banks and other lenders might seize assets like buildings and machinery if you can’t pay back their loans.

A real-world example of excessive leverage leading to corporate distress includes Toys“R”Us. The toy retailer’s $6.6 billion leveraged buyout in 2005 left it with unsustainable debt, contributing to its bankruptcy in 2017. This demonstrates how excessive leverage can leave companies vulnerable to market downturns and changing business conditions, underscoring the importance of maintaining a balanced capital structure.

Tools and resources for managing leverage

Managing leverage effectively requires the right tools and knowledge. Below, we offer some resources to help businesses navigate leverage:

Financial management software

• QuickBooks offers comprehensive accounting and financial management.
• Xero is cloud-based accounting software with real-time financial data.
• NetSuite is an enterprise-level financial management and ERP solution.

Financial analysis platforms

• FinBox offers leverage analysis tools for businesses.
• Finviz provides financial ratios and screening tools for public companies.

Further reading

• “Financial Intelligence” by Karen Berman and Joe Knight
• “Corporate Finance” by Jonathan Berk and Peter DeMarzo

Professional courses

• Financial Analysis on Coursera
• Corporate Finance Institute’s Financial Modeling & Valuation Analyst (FMVA) Certification

Introduction to leverage ratios

Leverage ratios are financial metrics that assess a company’s ability to meet its long-term financial obligations. These ratios are crucial for evaluating a company’s financial health and risk profile.

Common leverage ratios include the following:

Debt-to-equity ratio

Formula: Total Liabilities / Shareholders’ Equity

Example: If a company has $500,000 in liabilities and $250,000 in equity, the D/E ratio is 2:1.

Interest coverage ratio

Formula: EBIT (earnings before interest and taxes) / Interest Expense

Example: If EBIT is $100,000 and interest expense is $20,000, the ratio is 5, indicating the company can cover its interest payments 5 times over.

Debt ratio

Formula: Total Liabilities / Total Assets

Example: If total liabilities are $400,000 and total assets are $1,000,000, the debt ratio is 0.4 or 40%.

These ratios help investors, creditors, and managers assess a company’s financial leverage and risk. Lower ratios generally indicate less financial risk, but the ideal ratios can vary by industry and company size.

Leverage in personal finance

Leverage in personal finance involves using borrowed money to increase potential returns on investments or to make large purchases. Common examples include mortgages, car loans, and margin trading (borrowing money from a broker to invest in securities).

The key benefits of personal leverage are:

• Ability to make large purchases or investments with limited capital
• Potential for higher returns on investments
• Tax advantages (e.g., mortgage interest deductions)

But it also has some risks:

• Increased financial vulnerability during economic downturns
• Potential for negative equity if asset values decline
• Higher long-term costs due to interest payments

We offer some tips for responsible personal leverage management:

• Maintain a healthy (low) debt-to-income ratio
• Build an emergency fund to cover leveraged obligations
• Understand the terms of your loans or margin agreements
• Regularly review and adjust your leverage strategy as needed
• Consider the potential downside risks before taking on leverage

By understanding and carefully managing personal leverage, individuals can use it as a tool for building wealth while minimizing financial risks.

‍Need help? Hire a freelance financial analyst

Although operating and financial leverage focus on different aspects of a business, they contribute to additional risk in similar ways. So, you’ll want to ensure fixed and timely payments on all financial obligations!

Unfortunately, staying on top of your financial management and accurately forecasting operating income can be challenging, especially if this isn’t your area of expertise. For additional assistance, we recommend hiring freelance financial analysts through Upwork to help you with all your borrowing needs while ensuring minimal risks.

And if you’re looking to start your own freelance accounting business and assist other organizations in managing their borrowing, Upwork has a number of financial analysis jobs available.