Leverage, in general, can defined as any technique that is used to multiply gains and losses. By this definition the use of leverage creates risk, and thus will always necessitate a tradeoff between risk and return. As in any situation of this sort, added risk can produce benefits for a firm, but it can also lead to detrimental consequences. Show
When considering the benefits of operating leverage, it is appropriate to consider the contribution margin, or the excess of sales over variable costs. When variable costs are lower, the contribution of sales to profits will be greater. In other words, a company with higher operating leverage has the potential to generate much larger profits than a company with lower operating leverage. For example, the variable costs for a software company, such as packaging and the cost of various media devices (like CDs), are very low compared to its fixed costs, such as research and development. Therefore, once a certain break-even point is reached, the contribution that sales make to profits is much higher than it would be if a greater portion of the costs were variable. Problems can arise if a company has very high fixed costs, and if a company has difficulty selling enough units to break even on a particular investment. This is referred to as "business risk," since it arises from the inherent risk of doing business. In other words, the uncertainty of generating a necessary amount of sales is a dilemma all businesses face. Just as the use of operating leverage can lead to greater profits, if a company is able to reach a given, break-even point, so too can the use of leverage drastically multiply losses if that point is not reached. Possible Business RisksThis chart represents a list of the possible risks involved in running an organic business. Risks such as these affect sales, which in turn affect the amount of operating leverage a company should utilize. What is Operating Leverage?
Alternatively, Operating Leverage can be defined as the capability of the firm to use its fixed expenses to generate better returns. For example, the above graph notes that companies like Accenture, Cognizant, Automatic Data Processing, and Paychex have lower leverage (~1.0x). In contrast, companies like Delta Airlines, China Eastern Airlines, and National Grid have a higher Leverage.
You are free to use this image on your website, templates, etc., Please provide us with an attribution linkArticle Link to be Hyperlinked Why do some companies have higher operating leverage while others have lower leverage? What are the things we should be mindful of as financial analysts? Understanding the Company’s CostsAs we all know, no product is manufactured free of cost by any organization. Finally, various costs are incurred to bring the product on the shelf, ready for the consumers to buy and consume. All these costs incurred can be bifurcated into two main categories – fixed costs and variable costs. What are the fixed costs?
What are the variable costs?
What are semi-variable / semi-fixed costs?
Note: There is a thin line between fixed and variable costs differentiation. What is fixed for a given company, and a given situation may be variable for the same company for a different situation? The best example is the workforce costs. The salary paid to an accountant is a fixed cost, whereas wages paid to the workers per product is a variable cost. So even though both are included as workforce costs in a company, they can still be bifurcated into fixed and variable. How to Interpret Operating Leverage?Operating leverage measures the company’s fixed costs as a percentage of its total costs. Therefore, a company with a higher fixed cost will have higher leverage than a higher variable cost. Lower operating leverage –
Higher operating leverage –
Companies generally prefer lower operating leverage so that even in cases where the market is slow, it would not be difficult for them to cover the fixed costs. Related Topics – Income Statement InterpretationThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, Profit MarginsProfit Margin is a metric that the management, financial analysts, & investors use to measure the profitability of a business relative to its sales. It is determined as the ratio of Generated Profit Amount to the Generated Revenue Amount. read more Operating Leverage FormulaIt is the percentage change in operating profit relative to sales. It is also known as the “Degree of Operating Leverage or DOL.” Please note that the greater use of fixed costs, the greater the impact of a change in sales on a company’s operating income. Degree of Operating Leverage Formula = % change in EBIT / % change in Sales. Let us take a simple example.
This means that Operating profit changes by 2% for every 1% change in Sales. Also, have a look at EBIT vs. EBITDA – Top differencesEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company's overall operational profitability by summing the depreciation and amortization expenses to the operating profit.read more. Calculate Operating Leverage of Colgate
Calculate Operating Leverage of AmazonLet us now calculate Amazon’s DOL. Below is Amazon’s Income Statement for 2014, 2015, and 2016. source: Amazon SEC Filings DOL formula = % change in EBIT / % change in Sales DOL of Amazon – 2016
DOL of Amazon – 2015
Reasons for Higher Leverage for Amazon
Accenture Examplesource: Accenture SEC Filings DOL Formula = % change in EBIT / % change in Sales DOL of Accenture – 2016
DOL of Accenture – 2015
Reasons for low DOL of Accenture
IT Services Firm ExampleSalient Features of IT Services Firm –
Below is the list of the Top IT Services firm and their DOL for the year of 2016-2017
source: ycharts
Airline Sector ExampleSalient features of the Airline Sector
Below is the list of some of the Top Airline companies along with their DOLs for 2016-2017
Business Services Companies ExampleSalient features of Business Services
Below is the list of Top Business Services Companies along with their 2016-17 Leverages
source: ycharts
Utility Companies ExampleSalient features of Utilities Sector
Below is the list of Top utility companies with their Market Cap along with 2016-2017 DOLs
source: ycharts
ConclusionWhile we analyze a company, we must look at its Operating Leverage. DOL helps us evaluate how sensitive its operating income is concerning changes in Sales. Higher DOL will result in a bigger change in Operating income when sales increase. However, in the case of adverse situations of Sales decrease, such companies’ Operating Income will get hit the most. On the other hand, companies with Lower DOL will see only a proportional change in Operating IncomeOperating Income, also known as EBIT or Recurring Profit, is an important yardstick of profit measurement and reflects the operating performance of the business. It doesn’t take into consideration non-operating gains or losses suffered by businesses, the impact of financial leverage, and tax factors. It is calculated as the difference between Gross Profit and Operating Expenses of the business.read more. As an analyst, you should fully understand a company’s cost structureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.read more, fixed costs, variable costs, and operating leverage. This information is very helpful when you forecast financials and prepare its financial model in excelFinancial modeling in Excel refers to a tool used for preparing the expected financial statements predicting the company's financial performance in a future period using the assumptions and historical performance information.read more. Frequently Asked QuestionsHow to interpret whether the operating Leverage is good or not? Operating leverage is the primary indicator comparing a company’s fixed costs with the variable costs. Higher operating Leverage means the company has more fixed costs, which means the company utilizes fixed assets more efficiently and hence has a better chance of receiving more profits. How can businesses improve their operating Leverage? A company can improve operating Leverage through the acquisition of more fixed assets by the companies. It helps the company instigate more assets to support the core functioning, thus improving the operating Leverage. Can the operating Leverage ever be zero? The operating Leverage can be zero when the firm possesses no fixed assets. It will mathematically indicate that, in the company’s financials, the percentage change in EBIT will be the same as the percentage change in sales. Due to this, the operating Leverage is absent. Recommended ArticlesThis article has been a guide to operating leverage, formula, and calculation. Here we also take a degree of operating leverage examples of companies like Colgate, Amazon, Accenture, and sectors including IT Services, Utilities, Business Services, and Airlines.
When compared to companies with low operating leverage companies with a higher operating leverage will have?A company with high operating leverage has a high percentage of fixed costs to total costs, which means more units have to be sold to cover costs. A company with low operating leverage has a high percentage of variable costs to total costs, which means fewer units have to be sold to cover costs.
Which is better high operating leverage or low operating leverage?Generally speaking, high operating leverage is better than low operating leverage, as it allows businesses to earn large profits on each incremental sale. Having said that, companies with a low degree of operating leverage may find it easier to earn a profit when dealing with a lower level of sales.
What does a high and low operating leverage indicate?Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product. Low-operating-leverage companies may have high costs that vary directly with their sales but have lower fixed costs to cover each month.
What is the benefit of high operating leverage?The benefits of high operating leverage can be immense. Companies with high operating leverage can make more money from each additional sale if they don't have to increase costs to produce more sales.
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