Discuss the relationships between operating, financial and combined leverage? Does the firm use financial leverage if preferred stock is present in its capital structure? What type of effect occurs when the firm uses operating leverage?
Operating leverage is the use of company’s assets in operations when fixed costs are present. It takes into account the sales and EBIT to find the effect of fixed operating costs. Financial leverage is the use of debt in the company’s capital structure where it has to pay interest expense. It used the EBIT and the EPS to measure the effect of interest expense. Operating leverage is ideal when it is lower, and Financial leverage is the opposite so more it is more attractive when it is higher. The combined (obviously J ) is a mixture of the two approaches that “…the result of the combined effects of both operating and financial leverage…and can cause large variations in the EPS” (Keown, Martin, & Petty, 2014). The firm can still have financial leverage when preferred stock is present in its capital structure. Although, it does make things riskier and puts the owners of common stock in more danger with the presence of preferred stock. Any additional variability can change the EPS and earnings to the common stock holder. Operating leverage has a great impact on looking at the input costs for a product or service. Therefore a company that has a higher variable cost (low operating leverage) can bode well for management and therefore investors because they need to sell fewer units to recuperate their costs.