Operating Leverage — Microsoft Excel
In this article, we will walk you through the fantastic journey of learning operating leverage in finance and along with that approach we will understand how we operate leverage and how it is exactly implemented onto the business.
Operating Leverage
When we talk about Operating Leverage in Finance, what is the leverage in that and what is a lever? Here, our leverage is Fixed Cost. Fixed costs have a significant impact on a business and an increase in sales can lead to a substantial increase in profits. The exact increase in profit depends on the magnitude of the fixed costs, as they remain constant regardless of the level of sales. As sales increase, the contribution margin
the amount of revenue that exceeds variable costs also increases and a greater
portion of that revenue can be applied towards covering the fixed costs. This results in a higher profit margin, with the degree of increase depending on the amount of fixed costs relative to the contribution margin.
Let’s try to understand this with an example of Airlines.
The Fixed Cost is very high in the Airlines industry.
- Fixed Costs: Aircrafts, Hangars and Insurance.
- Variable Costs: Jet Fuel and Runway Charges.
Aircrafts leased or bought is a fixed cost for a company.
Hangars must be rented wherever these aircrafts are parked; this is also a fixed cost. The same goes for insurance, we must take insurance for aircrafts and it is very
expensive.
Jet fuel must be paid for whenever the planes fly and we will incur runway charges
when the planes are in use, these are the variable costs. The more sales are made, the more our runway charges will increase and the more jet fuel will be consumed. As our incremental sales increase, our fixed costs will remain the same. Let’s say
if the sales are double, then our profits can be 3-4 times. This is the advantage of an operating leverage company. But it also has a disadvantage, the company can
default as quickly if the economy or the market conditions are bad.
Now, let’s talk about a Low Operating Leverage Company. In that case, fixed costs are very less in the Consulting or Service Industry.
- Fixed Costs: Rent and Utilities
- Variable Costs: Salaries
Monthly rent or utilities bills are fixed costs that are too low. The variable cost is very high in these, which is the salary of the employees. So, the more work comes, the more people will be hired. And if there is no work in consulting or service industry,
no employee will be hired.
Degree of Operating Leverage: The degree of operating leverage measures how much a company’s operating income changes in response to a change in sales.
Formula:
Where,
DOL is Degree of Operating Leverage.
Financial Leverage
When we say a company is a high financial leverage company, when it takes a lot of debt and must pay high interest on it. Let’s say in real estate, companies must take a
lot of debt. Assume that we must make a building and rent it, people do not prefer to use their own money, they prefer to use a bank’s money. If the return on investment is greater than the interest paid on the loan taken from the bank, then the company can grow rapidly.
In a real estate company, let’s say the rent is very good from a particular location and the company is getting a great total return on investment. Suppose we are getting 20% return from rent and are paying 12% interest on debt; our total profit will be 8%,
so the company can grow fast. But if we are getting only 6% returns from rent and are paying 12% interest on debt, we are in 6% loss directly, so no one can stop this
company from going down.
- Degree of Financial Leverage: If the more debt the company takes, the more we say that its financial leverage is high. However, an excessive amount of financial leverage increases the risk of failure since it becomes more difficult to repay debt.
- The degree of financial leverage (DFL): It is a multiple that measures how the net
profit of a company will change in response to change in interest.
Formula:
Where,
DFL is Degree of Financial Leverage.
Conclusion
Finally, we will understand the fundamental of operating and financial leverage in finance and along with that we also discussing how it is beneficial sometimes, but it is based on market conditions and if the market condition is bad than obviously, it leads to losses or default of a company.
