There are a number of possibilities to boost returns for shareholders without selling more. Two of those ways are through the use of operating leverage and financial leverage. Operating leverage shifts the balance between fixed costs and variable costs, while financial leverage boosts returns through the changing capital structure.
Operating Leverage Low Volume
Operating leverage is the accounting concept of having high fixed costs and low variable costs versus having high variable costs and low fixed costs. This is extremely beneficial when volumes are high. For example, Companies A and B both sell widgets for $10 apiece. Company A has no fixed costs and variable costs of $8 a widget, while Company B has fixed costs of $1,000 and no variable costs. Lets say the number of widgets sold is 50 units. To calculate the total profit, multiply the profit per unit times units sold, minus the fixed costs. For Company A, the equation is $2 times 50 units for a profit of $100. For Company B, the equation is $10 times 50 units minus $1,000 for a total profit of -$500.
Operating Leverage High Volume
In the example where the number of widgets sold is a high number, the profit advantage changes. Suppose the number of widgets sold is 200 units. The profit for Company A is just $2 times 200 units for a total profit of $400. The profit for Company B is 200 units times $10 minus $1,000 for a total profit of $1,000. Company B successfully used operating leverage to generate higher returns.
Financial leverage is the concept of amplifying returns for shareholders through the use of debt. For example, there are two companies with identical attributes and accounting figures, except capital structure and interest expense. Company A has $5 million in equity capital and $5 million in debt capital. Company A pays 10 percent interest on its debt. Company B has $10 million in equity capital. Both companies earn $2 million in operating income. For Company B this generates a return on equity of 20 percent. For Company A, the net income is $1.5 million because you must subtract the debt expense of $500,000. The return on equity is therefore $1.5 million divided by $5 million, or 30 percent. Note that return on equity is calculated by dividing net income by equity capital. Company A successfully used the concept of financial leverage to amplify the returns for shareholders.
The main difference is in the type of leveraged used. Operating leverage uses tools available in the day-to-day business activities to boost returns by shifting the balance between variable costs and fixed costs. Financial leverage uses leverage outside of the main business through the use of debt to increase returns.