Relationship between financial and operating leverage: In business terminology, leverage is used in two senses: Financial leverage & Operating Leverage

Financial leverage: The effect which the use of debt funds produces on returns is called financial leverage.

Operating leverage: Operating leverage refers to the use of fixed costs in the operation of the firm. A firm has a high degree of operating leverage if it employs a greater amount of fixed costs. The degree of operating leverage may be defined as the percentage change in profit resulting from a percentage change in sales. This can be expressed as:

= Percent Change in Profit/Percent Change in Sales

The degree of financial leverage is defined as the percent change in earnings available to common shareholders that is associated with a given percentage change in EBIT. Thus, operating leverage affects EBIT while financial leverage affects earnings after interest and taxes the earnings available to equity shareholders. For this reason operating leverage is sometimes referred to as first stage leverage and financial leverage as second stage leverage. Therefore, if a firm uses a considerable amount of both operating leverage and financial leverage even small changes in the level of sales will produce wide fluctuations in earnings per share (EPS). The combined effect of both these types of leverages is after called total leverage which, is closely tied to the firm's total risk.