Techniques Used in Ratio Analysis
Ratio, as the name suggests, is nothing more than one number divided by the other. However, they become useful when they are put in some sort of context. This means that when an analysts looks at the number resulting out of a ratio calculation he/she must have a reasonable basis to compare it with. Only […]
How Does The Failure of Silicon Valley Bank Affect Stakeholders
The fall of the Silicon Valley Bank happened very suddenly. The bank had gone from a healthy functioning bank to near bankruptcy within 48 hours! As a result, the credibility of the entire American banking system has been brought into question. This is because commercial banks are not like regular organizations. In most cases, they […]
Types of Orders in the Forex Market
Why Orders are Important in Forex Markets ? There is a need for some form of automation in the Forex markets. This is because the market runs 24 by 7. Therefore the value of investor holdings and therefore their net worth keep changing 24 by 7. Hence if an open position is not managed for […]
Limitations of Accounting
Although accounting may be heralded as being the language of the business, it is definitely not error-free. This has been highlighted by the fact that accounting scams have occurred one after the other for many years. In fact, even after stricter regulation and tightening of accounting rules, accounting scams just don’t cease to stop. As […]
Pros and Cons of Neo Banks
In the previous article, we have already discussed what neo banks are. We now know the business model of neo banks. We are also aware of the various characteristic features of neo banks. It is important to note that a significant number of business organizations in Europe have already started migrating their banking needs to […]
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.
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.
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.
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.
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.
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