Question

Why is important for a firm to analyze operating and financial leverage in order to identify where the breakeven point is?

Answer 1

•   Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.
•   financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in its capital structure. The degree of financial leverage (DFL) measures the percentage change in EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT)

•   Operating leverage is an indication of how a company's costs are structured and is used to determine the break-even point for a company. The break-even point is where the revenue from sales covers both the fixed and variable costs of production. Financial leverage refers to the amount of debt used to finance the operations of a company.
•   Operating leverage measures the extent to which a company or specific project requires some aggregate of both fixed and variable costs. Fixed costs are those costs or expenses that do not fluctuate regardless of the number of sales generated by a company. Operating leverage can help companies determine what their break-even point is for profitability. In other words, the point where the profit generated from sales covers both the fixed costs as well as the variable costs.

•   Financial leverage is a metric that shows how much a company uses debt to finance its operations. A company with a high level of leverage needs profits and revenue that are high enough to compensate for the additional debt they show on their balance sheet.
•   Investors look at a company's leverage because it is an indicator of the solvency of the company. Also, debt can help magnify earnings and earnings per share. However, there is a cost associated with leverage in the form of interest expense. When a company's revenues and profits are on the rise, leverage works well for a company and investors. However, when revenues or profits are pressured or falling, the debt and interest expense must still be paid and can become problematic if there is not enough revenue to meet debt and operational obligations.