Meaning of Leverage/gearing
Leverage refers to increased means of accomplishing the purpose of the company. In the financial world, leverage refers to the ability to use fixed-cost assets or funds to increase the return to its shareholders. The leverage related to investment activities is called operating leverage.
Operating leverage is caused by to nature of fixed costs incurred in the company. Operating leverage is defined as the ability of the company to magnify the effects of changes in sales on its earnings before interest and taxes.
Operating leverage consists of two important costs i.e. fixed cost and variable cost. The company is said to have a high degree of operating leverage if it has a higher amount of fixed cost and a lower amount of variable cost. Operating leverage can be determined with the help of break-even analysis.
Operating leverage can be calculated with the help of the following formula:
Operating leverage = Combined leverage/Financial leverage
Degree of Operating Leverage
The degree of operating leverage depicts the percentage change in the profits resulting from a percentage change in the sales. It can be calculated by following formula:
DOL = Percentage change in EPS/Percentage change in sales
High and Low Operating Leverage
It is important to compare leverages between companies in similar industry. The operating leverages is highly important in the case of commodity business. This is because some industry has different operating leverages than others.
Many companies have recurring fixed costs meaning they occur every month regardless of sales volume.
As long as the business earns substantial profit on each sale and sustains adequate sales volume, fixed costs are covered and profits are earned.
Other companies have variable costs only when sales happen. This includes labor to assemble products and the cost of raw materials used to make products.
Few companies earn a lesser profit on each sale but may have lower sales volume and may generate enough revenue to cover fixed costs.
For example, a steel mining company has a greater fixed cost in machines and employees’ expenses.
This means that it will have high operating leverage. On the other hand, consulting firms would only have cost in the nature of being variable.
This will lead to lower operating leverage. Another example would be online education. The fixed costs are negligible and only costs are variable. The business thus has low operating leverage.
Examples of Operating Leverage
Let us take the example of Chegg. Most of the expenses of Chegg are variable. The experts are hired on a seasonal basis and paid on the basis of the volume of questions asked by the student.
With each dollar in sales earned beyond the break-even point, the company makes a profit, and hence Microsoft has low operating leverage.
In the extreme opposite is the oil and gas sector. Let’s take Aramco, it has high costs in comparison to variable costs.
This was seen in the recent negative crude oil prices that the company has to pay for the delivery of oil in the United States since there was near to zero demand for oil and all the storage capacity has been done.
Uses of Operating Leverage
Operating leverage is one of the techniques to measure the impact of changes in sales which leads to a change in the profits of the company. If there are sales in the company, it would naturally contribute to profit.
The following are the uses of operating leverage:
- Operating leverage helps to identify the position of fixed cost and variable cost.
- Operating leverage helps to define the relationship between the sales and revenue of the company during a particular period.
- Operating leverage depicts the amount of fixed cost which is likely invested in operating expenses of the business activities.
- Operating leverage helps to provide the overall position of fixed operating costs.