Understanding Operating Leverage (+3 Case Studies)
How are you looking to do more with your business? I know, there is a lot that you need to take care of.
However, if you’re looking to have the adequate cash flow at all times, you need to focus on your bookkeeping too.
What if you don’t achieve your sales targets? There can be seasonal changes, depending on the nature of your business.
When the sales are higher, you need to ensure that you have more funds to achieve greater efficiency and higher sales.
Yet, accounting can confuse the best of us, right?
Even if you have an accounting team, are they doing it right?
Organizations significantly lean on accounting concepts.
Don’t worry, though. Once you are clear as to what you need, you can implement them with ease.
Accounting is not only crucial for businesses but in everyday life too.
In accounting, two particular terms can be particularly challenging to understand – Operating Leverage and Financial Leverage. (You flinched, didn’t you?)
These topics are difficult to understand but are just as important for students as they are for professionals.
To understand them, first, let’s see what the term ‘Leverage’ means in accounting and then we’ll jump to the more complex and dreaded types of leverages.
HOW DO YOU GAIN THE RIGHT LEVERAGE?
When you use the debt or any amount to purchase assets, operate a company, or gain possession of any other company you are ‘leveraging’ it.
It is basically an investment strategy to use borrowed funds to increase the Return on Investment.
There are four types of leverages you must know about,
- Operating Leverage
- Financial Leverage
- Capital Leverage
- Working Capital Leverage
It is clear that with lower leverage the effort required is more, but the output that you get is considerably less.
Operating leverage is dependent on the cost structure of the company, and financial leverage depends on the capital and investment of the company.
The terms Financial Leverage and Operating Leverage are often used in finance, but do you know what they mean?
Lower leverage translates to lesser output. Operating leverage is dependent on the cost structure of the company, and financial leverage depends on the capital and investment of the company.
But why do companies need leverage?
Leverage is essential to measure the operating risk, financial risk, design appropriate capital structure, and increase profits.
Measuring Operating Risks
Companies sometimes are not able to cover their fixed costs or operating costs. Leverage plays an important role to manage and measure such risks.
Measuring Financial Risks
Similar to measuring Operating risks, this is another application of leverage, useful to measure the financial risks that a firm takes.
Helps to Design Appropriate Capital Structure
Leverage helps you to manage debts and equity using several strategies. For this, Operating Leverage and Financial Leverage are used simultaneously or in combination.
Increases Profit Significantly
The firm uses fixed costs to increase profitability and generates better results. Leverage ensures utilizing the maximum of the fixed costs to increase the profit.
UNDERSTANDING HOW YOUR BUSINESS BENEFITS FROM THE RIGHT OPERATING LEVERAGE
The terms Financial Leverage and Operating Leverage are often used in finance, but do you know what they mean?
These are two different concepts people use synonymously, but they are not the same. When you look at each of them individually, you’ll find out how different they are.
Leverage on its own is the difference in one variable because of another variable.
Let’s understand these concepts first, based on these we’ll go through some simple examples and case studies to understand the concept of Operating Leverage.
WHAT IS OPERATING LEVERAGE?
In simple terms, Operating Leverage is the extent of fixed and variable costs in a company.
Fixed costs are those who don’t vary based on the income generated by the company.
Variable costs, on the other hand, can be changed and managed with the production rate as the salary of employees, raw materials, and so on.
If the sales increase, the percent of profit that increases along with the sales is the operating leverage. Now let’s see what financial leverage is.
Financial Leverage vs. Operating Leverage
To understand operating Leverage, you need to know how it is different than Financial Leverage.
Definition: The amount of debt in a company intake is directly proportional to the financial leverage of that company.
You need to do less to earn more profits here. However, that does not make this strategy better than Operating Leverage. The debt is a fixed cost in this case, with the revenue you must clear this debt. A greater debt isn’t a great sign.
The concepts of Operating Leverage and Financial Leverage are essential in maintaining the profit margin of a company.
There are differences between these two types of leverages; they are discussed briefly in the following section.
Operating Leverage vs. Financial Leverage
With higher effort, the output or profit generated is lesser in Operating Leverage. Whereas in Financial Leverage the effort you put in decreases with debts, but the profit or output increases significantly.
Lower or no debt means higher operating leverage, lower financial leverage and the other way around.
One thing that is common in both cases is that the company’s variable cost is directly proportional to sales.
For Operating leverage, higher production spreads out the fixed costs among more units reducing the fixed cost of every unit thus increasing the variable cost.
But in the case of financial leverage, more units mean more debt thus increasing the financial leverage of the company.
DIFFERENCE BETWEEN OPERATING AND FINANCIAL LEVERAGE
Now, operating leverage and financial leverage have a fundamental difference – we will take a look at it below.
What they are about?
Operating Leverage is about a firm’s fixed costs on the other hand financial leverage is all about the firm’s capital structure.
The Measurement Differs
Both types of leverages can be measured using various methods but what do they measure?
Operating Leverage measures the operating risks of businesses and financial leverage manages financial risks of an organization.
Formulas and Calculation
Calculating these two types of leverages can be done using different formulas.
One formula to calculate Operating leverage is when you divide the contribution or the operations of the firm by the EBIT of the firm.
To calculate Financial Leverage, divide the EBIT by the EBT of the firm.
Impact of Both the Phenomena
When the Degree of Operating Leverage or DOOL is higher, it means that the firm is taking a more operating risk. On the other hand, if the operating risk is higher, it means a greater financial risk for the organization.
Many organizations often take financial risks rather than operating risks and so, financial leverage is more preferred by the firms than Operating Leverage.
You can further clarify these two types of leverages by case studies and instances. But we will be focusing on Operating leverage and how to understand it better.
THE THREE CASE STUDIES TO HELP YOU KNOW ABOUT OPERATING LEVERAGE
Let’s start with a few simple examples first. After these; we’ll gradually progress to complex case studies.
Example 1: Airline’s Operating Leverage
It is the simplest and most widely used example to understand Operating Leverage.
Consider any airline company.
The fixed costs for this company are going to be significantly higher than companies in most other industries.
The cost of leasing airplanes, leasing hangars for those planes, and insurance are all fixed.
These costs must be paid monthly, quarterly or annually whether the airline company gets customers or not.
But the variable costs can be managed like the cost for fuel, refreshments for the passengers, and the salary of the crew (to some extent).
This means that without customers and take offs the airline company will still have to pay for its aircraft and insurance. However, variable costs like fuel for the aircraft and refreshments for the passengers can be reduced significantly.
When the sales increase, the company raises more revenue, and this results in a profit. But with no sale or lower sales, the company still has to pay its fixed cost, resulting in a loss.
The DOL or Degree of Leverage, tells us how well a company manages its fixed costs to get the maximum profit.
DOL = (Sales – Variable Costs) / Profit
Where Profit can be calculated using the following formula,
Profit= Sales – Variable Costs – Fixed Costs
For example, if ABC airline company’s ticket sale is $4000, Variable Cost is $400, and Fixed Cost is $1100, its DOL will be,
DOL = (4000 – 400) / 2500 = 1.44
If the sales increase by 10% in this case, ABC airline will experience a 14% rise in their profit.
However, if the company doesn’t have as many ticket sales, it could lead to a loss.
An Operating Leverage magnifies both, profits and losses, based on the economic condition of that industry.
Example 2: A Software Company
Consider a software company; this company will naturally have higher fixed costs.
Examples of fixed costs would be the salaries of the developers no matter how many applications or solutions they design.
And the variable cost is the cost of the sales that occur; you cannot be sure how many websites or applications the software company will develop for its clients.
The Operating Leverage, in this case, would be low and the efforts required to be put in by developers be spontaneous and high.
Another example would be comparing Google and Walmart.
The point at which Google starts getting its profit is after paying the salary of every employee which means that Google has a high Operating Leverage.
But with Walmart, the variable cost of the number of goods sold determines the profit or loss.
This means that Walmart has few fixed and more variable costs leading to a low Operating Leverage.
Fixed costs remain the same at all time not depending on the goods or services sold or produced. Some examples of the fixed cost would be,
Now that we have a clear picture of what Operating Leverage is, let’s understand the concept even better with case studies.
With all the given examples and case studies the concept of Operating Leverage can now be understood in a comparatively better way.
There are several confusing explanations for this business phenomenon however, the simplest ones are stated and explained here for you to understand it better.
CASE STUDY 1: STUDY OF MANAGERIAL DECISION MAKING LINKED TO OPERATING AND FINANCIAL LEVERAGE
This is a case study taken from Researchgate.net, in which the researchers have studied in detail the effect of Operating and Financial leverages of a Management Company and simultaneously explained the firm’s Degree of Operating Leverage (DOOL) and Degree of Financial Leverage (DOFL)
For any company, the manager needs to find the right balance between the fixed costs and the debts or equity utilized to maximize profits.
In this case study, the researchers have found the significance of a well-balanced operating and financial leverage of a firm.
The general understanding of any firm’s capital structure, its leverages and use its equity shares and debt accordingly are essential for the manager.
With changes made in fixed costs, the Earnings Before Interests and Taxes (EBIT) or the Operating Leverage gets affected is what the study concluded.
The researchers also examined various risks that came with the Operating Leverage.
It was observed that as they increased only the fixed operating costs and not the sales quantity, the firm loses its operating profit as the employees have to put in more effort to meet the sales quantity.
It is clear if the firm uses only debts and equity then the Operating Leverage or EBIT gradually increases. However, in this case, the total earnings remain the same for the investors.
Similarly, in the case of 50% equity and 50% debt, the Operating profit decreases but the Profits after Taxes (PAT) increases.
This leads to an increase in total earnings from the equity and debt investors and enhances the shareholder’s wealth in the future.
With mixed capital, it is also observed that the Return on Equity also increases substantially for the firm.
In this case study, the researchers conclude that it is better to have both equity and debt capital in their firm’s structure.
Now, let’s take a look at a different case study for better understanding.
CASE STUDY 2: A STUDY ON CAPITAL STRUCTURE ANALYSIS OF TATA MOTORS LIMITED
In this case study, operating leverage is defined as the firm’s ability to use operating costs to maximize the effect of the sales before taxes and interest.
The formula derived for Operating Leverage here is that it is the sales divided by the Earnings Before Interest and Taxes.
i.e. Operating Leverage = Sales / Earnings Before Interest and Taxes
According to research and fixed costs from annual reports, a rise of 151% and a decrement of 10% has been seen in the years 2014-2015 and 2015-2016 respectively.
In the duration that the study was conducted the Operating Leverage shows a fluctuating trend.
For this reason, the company (Tata Motors) must make optimum use of their operating costs to meet the cost of changes in sales in the future on its earnings before interest and taxes.
Since both, financial and operating leverage play an important role in managing a firm’s ability to manage fixed costs, their sum gives the Combined leverage of the organization.
This value can be positive or negative based on financial and operating leverages.
It is then concluded for operating leverage that the company must make maximum use of its operating costs to meet the future effects of sales changes.
The main aim of any organization is to increase its value and minimize the cost of capital that it requires for it.
From the years 2012 and 2016, the operating leverage shows a lot of variations by increasing and decreasing in succeeding years.
The result of the study is that equity and debt should be managed carefully and must be sufficient to meet the fixed costs of Tata Motors.
Considering this and several other factors it was then concluded that Tata Motor’s Capital structure was satisfactory in those years.
CASE STUDY 3: A STUDY OF LEVERAGE ANALYSIS AND PROFITABILITY FOR DR. REDDY’S LABORATORIES
The case study for Dr. Reddy’s Laboratories explains leverage and its types with respect to the laboratory’s expenses. It states that leverage means to have a fixed expense for businesses.
The two kinds of leverage are,
i) Operating Leverage
ii) Financial Leverage
If a business has fixed expenses, then the leverage is operating leverage.
On the other hand, if the business bears funds in the form of interests, it is Financial leverage.
Operating Leverage impacts the change in sales and earnings before interest and taxes.
This research was conducted from the year 2010 to 2014 and shows the trends of operating leverage have been rising and falling significantly.
Leverage analysis indicates the financial performance in the long run.
The research shows that there is a direct relationship between profit and leverage.
The average ratio of Operating Leverage maintained by Dr. Reddy’s Laboratories is 1.33; this clearly shows us that the firm does not maintain optimum financial leverage.
The debt owned by Dr. Reddy’s Laboratories was 17 percent over its total capital. It shows that the laboratory is heavily dependent on its shareholders for as much as 83 percent of its funding.
It is found that the Degree of Operating Leverage is negatively proportional to the laboratories Return on Investment.
So, it can easily be said that the Operating Leverage of this laboratory was not in good condition from the study between 2010 to 2014.
The suggestion that the researchers presented to Dr. Reddy’s Laboratories is that they manage their borrowed and owned funds in a balanced manner and not be completely dependent on one of them.
In simple terms, operating leverage refers to the reaction of the company’s net income to a change in the sales quantity.
It measures the proportion of fixed costs in a company’s capital structure to maximize profit.
Firms with higher fixed costs and lower variable costs generally have higher Operating Leverage.
To conclude, depending on the industry Operating Leverage can be high or low to maximize sales.
It can be defined by the organization’s capability to use fixed costs to their advantage and generate better returns.
One other way to look at Operating Leverage is by examining that firms can lower fixed costs and increase their profits without compromising their selling price or the number of units that they sell.
All 3 of the case studies show that firms often miscalculate their fixed costs and equities resulting in dwindling Operating costs.
It is also one of the most important factors that affect business risks.
A company that keeps a high margin to generate sales and low variable costs has high operating Leverage.
Operating Leverage must be considered from different firms of the same industry to calculate an average Operating Leverage Rate to set as a benchmark for companies.
This makes the calculation process of Operating Leverage more effective.
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