Leverage Analysis

Operating leverage measures how much a company's operating income (EBIT) changes when its sales change. It exists because of fixed costs. If a company has high fixed costs, it has high operating leverage. This means a small increase in sales will result in a big increase in EBIT. For example, a cinema hall has fixed costs for the building and screen. Once the seats are filled beyond a certain point, every extra ticket sold is almost pure profit.

Combined leverage provides a complete view of the total risk of a company. It combines both operating and financial risk. It shows the impact of a change in sales on the final Earnings Per Share (EPS). A company with high operating leverage should ideally keep its financial leverage low to avoid too much total risk. For example, a startup with high rent should avoid taking too many loans in its early stages.

Financial leverage measures the use of debt in a company's capital. It shows how much the Earnings Per Share (EPS) will change if the operating profit (EBIT) changes. It is also called 'trading on equity'. If a company uses more loans instead of own capital, its financial leverage increases. For example, if a business earns 15% on its projects but only pays 10% interest on its loan, the extra 5% belongs to the owners.