Operating Leverage and Corporate Financial Policies

Using a measure of operating leverage that directly reflects the importance of fixed operating costs in firms’ cost structures, we show that high fixed cost firms have lower leverage ratios and also much larger cash holdings than low fixed cost firms. This conservative behavior is not solely a result of a trade-off between operating leverage and financial leverage, since even high fixed cost firms without any debt in their capital structure have significantly larger cash holdings than similar low fixed cost firms. We show that the conservative financial policies allow high fixed cost firms to limit the amount by which they have to cut investment if sales are low. Our evidence also suggests that the financial conservatism of high fixed cost firms is value-maximizing. We conclude that operating leverage is an important determinant of financial policies and helps explain why many firms have very low net leverage ratios.