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.