What is the fundamental difference between operating and financial leverage?

The correct answer identifies that operating leverage relates to fixed costs, while financial leverage pertains to debt financing.

Operating leverage arises from the presence of fixed costs in a company's cost structure. Companies with high operating leverage have a higher ratio of fixed costs relative to variable costs, meaning that changes in sales will have a significant impact on operating income. When sales increase, these fixed costs do not change, allowing profits to rise more sharply. Conversely, if sales decline, the same fixed costs can lead to a more significant drop in profitability.

On the other hand, financial leverage refers to the use of debt to finance a company’s operations. When a company takes on debt, it increases its financial obligations, which can amplify returns on equity when the business performs well. However, it also introduces risk, since the company must be able to generate enough income to cover interest payments on the debt.

In summary, the distinction lies in the type of leverage being discussed: operating leverage relates to the fixed versus variable cost structure affecting operational outcomes, while financial leverage centers on funding operations through debt, influencing returns and financial risk.