The degree of operating leverage of a company is very important from
an investor’s standpoint. Although it shows the riskiness of a venture,
it also shows the efficiency of a company. Just like, financial leverage
arises out of the capital structure of a company, operating leverage
arises out of its cost structure. If a company has too many expenses
which are fixed in nature, the company is said to have high operating
leverage.
Typically companies that are highly mechanized have high operating
leverage. This is because they have replaced labor which is a variable
cost by depreciation on machinery which is a fixed cost. This creates
debate whether having a high operating leverage is a bad thing. Henry
Ford was amongst the first to use operational leverage on a large scale
and build cars at a fraction of what it would cost earlier. This idea
was soon followed by many others and high operating leverage became the
norm
Formula
Degree of Financial Leverage = % Change in Sales / % Change In EBIT
The ratio makes a reasonable assumption that accounting policies have
not changed so much that the Sales and EBIT figures do not remain
comparable across companies or across time.
Example
- Profit Magnification Example: In case a company has a high operating leverage, most of its costs are fixed. Consider for example, the movie business. The costs incurred to make the movie are fixed. Hence when tickets are sold, the first few tickets go towards recovery of the cost of production. However, once a breakeven point has been reached, entirely all the money goes towards the bottom line. Hence a slight change in sales has the capability to magnify and bring about a big change in EBIT.
- Loss Magnification Example: However, every lever has its flipside and operating leverage is no exception. Since most of the costs are fixed, in the vent of a downturn, the company does not have the opportunity to cut costs. In many cases, companies are not able to fulfill their requirements to meet the fixed cost obligation. Whereas all companies are hurt in the event of a downturn, companies with excessively high operating leverage are wiped out in such events.
Interpretation
Whether operating leverage is good or bad for a company depends on
the nature of its operations and stability of its cash flow streams. In
case of stable operations, high operational leverage in desirable and
even recommended.
