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

What you will learn

  • How does operating leverage impact a company's financial performance?
  • Which formulas can be used to calculate operating leverage?
  • What is the difference between high and low operating leverage?

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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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