Advantages and Disadvantages of Operating Leverage
Operating leverage is the measurement of the percentage change in operating income due to the change of sales. It is calculated by dividing a company’s change in operating income over the sale’s percentage change.
The higher a company’s operating leverage, the more sensitive its profits are to changes in its sale. Companies with high operating leverage have a greater potential for profitability but also face greater risks if their sale decrease.
Operating leverage is an important metric for investors and managers to consider when evaluating a company’s financial performance and potential for growth. High operating leverage can indicate that a company has a strong business model and is well-positioned for growth, but it can also indicate that the company is at risk of financial distress if its sale decrease.
It is important to note that, a company with high operating leverage is more sensitive to changes in sales and economic conditions. This means that a small change in sales volume can result in a much larger change in operating income.
In contrast, companies with low operating leverage are less sensitive to changes in sales volume and are often considered safer investments.
Operating Leverage = Change in EBIT / Change in Sale
- EBIT: is the amount of net income before income tax expense and the interest expense.
- Sale: the amount of income that company generates from providing service or goods to the customers.
Advantages of Operating Leverage
- Potential to increase Earning: A company with a high degree of operating leverage can potentially earn higher profits than a company with a low degree of operating leverage. This is because a higher proportion of fixed costs means that a greater portion of each additional unit sold goes straight to the bottom line.
- Risk and Return: Operating leverage also affects the risk-return tradeoff for investors. Companies with high operating leverage are considered riskier because a small decline in sales can have a large impact on profits. However, these companies also have the potential for higher returns if sales increase.
- Lower Break-Even Point: A company with a high degree of operating leverage will have a lower break-even point, meaning it needs to sell fewer units to cover its fixed costs. This can be beneficial for a company during a recession or economic downturn when sales may be lower.
- Less Sensitive to Cost Changes: Companies with high operating leverage are less sensitive to changes in variable costs than companies with low operating leverage. This means that a small increase in the cost of goods sold will have a smaller impact on profits for a company with high operating leverage.
Disadvantages of Operating Leverage
- Increased Risk: A company with high operating leverage is considered riskier because a small decline in sales can have a large impact on profits. This can make it difficult for a company to weather economic downturns or recessions.
- Reduced Flexibility: High fixed costs can limit a company’s flexibility to respond to changes in the market. For example, if a company has a high degree of operating leverage and sales decline, it may not be able to reduce costs quickly enough to offset the decline in revenue.
- Lowered Profitability: Companies with high operating leverage may experience lower profitability during periods of low sales. This is because a higher proportion of fixed costs means that a greater portion of each additional unit sold goes straight to the bottom line, but a smaller portion of the revenue goes to the bottom line when sales decrease.
- Difficulty in Forecasting: High operating leverage can make it difficult for a company to accurately forecast its future earnings. This is because a small change in sales can have a large impact on profits, making it hard to predict how changes in the market will affect a company’s bottom line.
- Cash Flow Issues: High fixed costs can put pressure on a company’s cash flow. This is because fixed costs must be paid regardless of whether a company is generating revenue. This can cause a company to have difficulty paying its bills during periods of low sales.
- Difficulty in Obtaining Financing: Companies with high operating leverage may have difficulty obtaining financing from lenders and investors. This is because high fixed costs are viewed as a sign of financial instability and increased risk.