High operating leverage makes profits surge in a booming market and plunge in a falling market for a business.
Today I will try to explain it in a simple way. Grab a glass of immunity drink and let's get started.
Before moving on, get a sense of these two terms
Variable costs: These costs change in proportion to production output/revenues
Eg: Raw material cost
Fixed costs: As the name says, these costs are fixed
Eg: Rent
Going back to the thread
Say, you run a business which manufactures steel. You made an income of 10 lakhs for the year. Variable costs are 2 lakhs, Fixed costs are 6 lakhs. You earned an operating profit of 2 lakhs.
You are content with your business performance.
And next year, for some reason, the steel industry has grown pretty well.
You made an income of 15 lakhs. Variable costs are 3 lakhs, fixed costs are 6 lakhs taking your operating profit all the way up to 6 lakhs (200%⬆️)
You are pretty happy now with your business.
Moving forward to the next year, suddenly a pandemic has come from nowhere and brought recession everywhere.
You made an income of only 5 lakhs. The variable costs are 1 lakh. However, with fixed costs being the same, you made an operating loss of 2 lakhs (200%⬇️)
Financial trouble has come to you and you are very sad about it.
Now, take a moment to think why has the massive profit-making business turned into a loss one all of a sudden. The answer lies in high operating leverage.
Operating leverage lets you know how a change in the business revenues will impact operating profits.
Though there are many formulae, the most practical one is below
Degree of operating leverage= % change in operating profits / % change in sales
Applying the formula to the above cases, you get the operating leverage of 4 times.
It means for every 1 percent change in sales, your operating profit changes by 4 percent
As you can observe,
In the first case, sales have grown by 50% whereas operating profits grown by 200%
In the second case, sales have declined by 50% turning operating profits into losses with a massive decline of 200%
You have just witnessed operating leverage in action.
Generally speaking, a company with high gross margins and low variable costs will have high operating leverage and vice versa
To give you some real-life examples
An airline company like indigo will have high operating leverage because it has high fixed costs.
A retail store business like Dmart will have low operating leverage because it has low fixed costs.
To conclude, high operating leverage is a double-edged sword. Be cautious when investing in such a business especially during a recession.
Thats it folks. Like and retweet if u find the thread value-added. Enjoy your weekend.
Economic Moat, The Chief Source of Wealth Creation.
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An economic moat is a *distinct feature* a firm has over its competitors which helps it to protect its *profitability*
Why Economic moat matter?
Capital always chases returns. So when a firm gets highly profitable, the competition kicks in and brings down the rate of return to the cost of capital.