Degree of Operating Leverage Ratio
The degree of operating leverage of a company is very important from an investors 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.
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.
- Proprietary Ratio
- Interest Coverage Ratio
- Degree of Financial Leverage Ratio
- Degree of Combined Leverage Ratio
- Introduction to Cash Flow Ratios
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