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Understanding Operating Leverage: Concept, Formulas, and Implications, Lecture notes of Financial Economics

The Open University (OU)Financial Economics

The concept of operating leverage, providing examples and formulas to calculate it. Operating leverage refers to the degree to which a company's operating income is affected by changes in sales. the difference between high and low operating leverage, its impact on a company, and its relevance to investment strategies.

Typology: Lecture notes

2021/2022

Uploaded on 09/27/2022

kimball
kimball 🇬🇧

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What is Operating Leverage?
•Question: “What is the formula for operating leverage
when you’re analyzing a company’s financial
statements?”
•“Also, what does ‘high operating leverage’ mean? Is it
good or bad for a company to have high operating
leverage?”
•Plan: Explain the concept, show the calculations, and
explain the interpretation
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Partial preview of the text

Download Understanding Operating Leverage: Concept, Formulas, and Implications and more Lecture notes Financial Economics in PDF only on Docsity!

What is Operating Leverage?

  • Question: “What is the formula for operating leverage when you’re analyzing a company’s financial statements?”
  • “Also, what does ‘high operating leverage’ mean? Is it good or bad for a company to have high operating leverage?”
  • Plan: Explain the concept, show the calculations, and explain the interpretation

What is Operating Leverage?

  • Answer 1: Not just one formula! At least 3, possibly 4…

 But they all relate to fixed vs. variable costs  As sales grow , how much trickles down into OpInc?

  • Answer 2: Not a matter of “good” or “bad”

 Any type of leverage  higher risk , higher potential rewards

What is the Formula?

  • Formula 1: Fixed Costs / (Fixed Costs + Variable Costs)

Problem: Companies don’t spell this out

  • Formula 2: % Change in OpInc / % Change in Sales
  • Formula 3: Net Income / Fixed Costs
  • Formula 4: Contribution Margin / Operating Margin

Is High Operating Leverage “Good”?

  • Positive: As sales grow, the company’s operating income grows by a substantially higher amount, and its operating margin actually increases
  • Negative: But when sales fall or the industry experiences a downturn, things get bad very quickly!
  • Financial Leverage: Similar to the risk of using debt in a leveraged buyout – more upside, but also more risk

Recap and Summary

  • Operating Leverage: How does revenue growth translate into Operating Income?
  • Formulas: Ideally look at Contribution Margin / Operating Margin or Fixed vs. Variable Costs…
  • Non-Ideal: % Change in OpInc / % Change in Sales
  • Meaning: Higher risk, but also higher potential rewards