Parties Involved in Infrastructure Debt Issuance
Bonds are commonly issued during infrastructure projects. The company holding the equity stake is generally the one issuing the bonds. This means that the company owning equity is the one actually borrowing money from the bondholders and, therefore, the one owing the money back. Even though the responsibility of repaying the loan lies with the […]
An Overview of Contracts and Why They are Important to Business and Society
Contracts govern all transactions whether they are between firms or between firms and private individuals. Indeed, in most of the developed world, any transaction or commercial exchange is usually not undertaken without a contract. This trend is also catching up in the developing world where contracts are increasingly becoming the norm. The importance of contracts […]
Pros and Cons of Financial Fair Play Rules
In the previous article, we have already seen how certain football clubs in Europe have been using their money power in order to muscle their way to the top of the league. Hence, in order to prevent this, certain organizations such as EUFA have created certain financial fair play rules. The aim of these rules […]
Equivalent Annual Costs
In the previous articles we have seen how we can convert a possible future stream of cash flows to its present value today to make investment decisions. We choose amongst competing projects and the one with the highest NPV is usually selected. But sometimes this may not be the appropriate thing to do. Example: Consider […]
What is Prototyping?
In the previous articles, we have already studied about the proof of concept as well as the minimum viable product concept. However, there is one more methodology that is commonly used in the product development stage after the seed funding has been received. This mechanism is known as “prototyping”. In this article, we will further […]
The degree of operating leverage of a company is very important from an investor’s standpoint. Although it shows the riskiness of a venture, it also shows the efficiency of a company. Just like, financial leverage arises out of the capital structure of a company, operating leverage arises out of its cost structure.
If a company has too many expenses which are fixed in nature, the company is said to have high operating leverage.
Typically companies that are highly mechanized have high operating leverage. This is because they have replaced labor which is a variable cost by depreciation on machinery which is a fixed cost. This creates debate whether having a high operating leverage is a bad thing.
Henry Ford was amongst the first to use operational leverage on a large scale and build cars at a fraction of what it would cost earlier. This idea was soon followed by many others and high operating leverage became the norm.
Degree of Financial Leverage = % Change in Sales / % Change In EBIT
The ratio makes a reasonable assumption that accounting policies have not changed so much that the Sales and EBIT figures do not remain comparable across companies or across time.
Consider for example, the movie business. The costs incurred to make the movie are fixed. Hence when tickets are sold, the first few tickets go towards recovery of the cost of production. However, once a breakeven point has been reached, entirely all the money goes towards the bottom line. Hence a slight change in sales has the capability to magnify and bring about a big change in EBIT.
Since most of the costs are fixed, in the vent of a downturn, the company does not have the opportunity to cut costs. In many cases, companies are not able to fulfill their requirements to meet the fixed cost obligation. Whereas all companies are hurt in the event of a downturn, companies with excessively high operating leverage are wiped out in such events.
Whether operating leverage is good or bad for a company depends on the nature of its operations and stability of its cash flow streams. In case of stable operations, high operational leverage in desirable and even recommended.
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