Thread by @FincademyIn

What is Operating Leverage ? How does leverage affect the company’s profit ?

A Thread 🧵👇

While doing companies or sectors research, one must have come across companies saying we are facing pressure on profit margin due to high operating leverage? or the company’s operating leverage will kick-off with recovery in the economy.

1/ What company is trying to say? Why does an investor here need to look into company's operating leverage?

In this thread you will understand:

(a) What is operating leverage?
(b) What determines high or low operating leverage?
(c) How leverage can impact a company’s profit?

2/ There are various ratios to evaluate the financials of the company and operating leverage often escapes from investors’ attention. This is one of the important measures which shows a relationship between a company’s fixed and variable cost.

3/ It evaluates the company’s fixed cost as a percentage of the total cost. Two scenarios determine the company’s with high and low operating leverage.

4/ Companies with ‘low operating leverage’ have sales mostly attributable to variable costs. The variable cost incurs as and when sales increases and the company need not have to generate more sales to cover its lower fixed cost.

5/ Low operating leverage companies able to manage their bottom-line margin during low sales or economic turmoil. And the company with ‘high operating leverage’ has a high proportion of fixed operating cost.

6/ It means the company uses more fixed assets to generate its sales. Once a company earns a substantial amount of sales to cover its fixed cost then each additional sale will have a positive impact on the company’s bottom line margin.

7/ Companies do not have to increase the cost to produce more number of units to meet demand. As the company already has set up its required fixed assets such as manufacturing facilities, well-paid employees, plant & equipment, etc.

8/ With the increase in companies’ sales and further growth prospects, investors might have a more positive outlook on companies with high operating leverage. Though high operating leverage benefits the company but is also vulnerable to abrupt shifts in the economy.

9/ When a company's cost is tied up in plant & machinery, distribution contract, rent cost, payment to employees, etc which cannot be easily cut to adjust fluctuation in sales revenue. So, in an economic downturn, the company’s profit might plummet.

10/ When a company is having high operating leverage i.e., fixed cost, the percentage change in operating profit due to the change in sales volume is greater compared to the percentage change in sales. This measure is referred to as the Degree of operating leverage (DOL).

11/ For instance, the DoL of a company is 1.40 means a 10% increase in sales generate 14% i.e., 1.40*10% increase in operating profit.

12/ Consider the airline industry which is exposed to high operating leverage due to its business structure. Usually, airline operating cost comprises of 30-40% fuel expense, approx. 15% of rental cost and other than this aeroplane maintenance,

13/ airport parking fees are fixed irrespective of flight operation. In covid-19, due to lockdown and low passenger traffic load, companies bottom-line plummet due to high fixed cost. If you observed in the below table, overall, the airline industry shows high

14/ operating leverage with a rise in the last two years. Negative operating leverage shows companies have a high proportion of fixed assets in total cost structure, and simultaneously, there was a decrease in sales.

15/ Capital intensive companies such as energy, airline, automobiles, steel manufacturing, real estate generally have high operating leverage whereas IT and data processing, retails, restaurants companies What has low operating leverage.

16/ As an investor, it is necessary to constantly monitor the company with high operating leverage since a small percentage change in sales can result in a drastic impact on the company’s earnings.

BY : @Dharmangi_S

17/ That’s it, hope you liked the thread.

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