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Leverage
Financial leverage reflects the degree to which a company has debt in its capital structure. The more debt is in the capital structure, the higher the leverage of the company. The reason is that with more debt, the company's financial risk is higher. It must pay out more of its earnings to the creditors, increasing the risk that there is nothing left for shareholders. However, of what is left, it is spread among fewer shareholders. As a result, a company that is highly profitable will return tremendously to shareholders. The returns to shareholders (ROE) are much more volatile the higher the degree of financial leverage a company has. If a firm uses preferred stock in its capital structure, that is still financial leverage. Preferred stock dividends do not typically change, so preferred stock does usually create and maintain an obligation to those shareholders, even if preferred stock is subordinated to debt.
Operating leverage reflects the degree of fixed to variable costs in a business. Fixed costs are the operating equivalent of debt, as they are costs that will be incurred no matter what happens (Investopedia, 2015). So in periods of low demand, the company is at significant risk of...
If a firm uses operating leverage, this creates a situation where the firm needs to focus on driving revenue as much as possible, to cover the fixed costs, because until they are covered the firm will not be profitable, but once they are it can shift to being profitable quite quickly.
Combined leverage is the combination of operating and financial leverage. There is sometimes a relationship between these different types of leverage. One principle with respect to financing is that fixed assets with a specific life span should be financed with debt that matches that life span. Thus, a company with a large amount of fixed assets (high operating leverage) might also have a high amount of financial leverage. An example of this would be an airline, which either buys aircraft with financing, or it has long-term leases on aircraft. In either case, the fixed asset is financed via a debt obligation, providing both a high level of operating and financial leverage. A software company would be the opposite. A software company has relatively few fixed costs, and may be financed entirely with equity…
References
Hamilton, W. (2012). Apple yields to investor pressure with decision to pay dividends. Los Angeles Times. Retrieved September 17, 2015 from http://articles.latimes.com/2012/mar/20/business/la-fi-apple-dividend-20120320
Investopedia (2015). Operating leverage. Investopedia. Retrieved September 17, 2015 from http://www.investopedia.com/terms/o/operatingleverage.asp
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