The financial analysis of a company is done by different methods. Ratio analysis is the most commonly used method for assessing the firm’s financial health, profitability, and riskiness. The most common measures used by most investors and third-party stakeholders are return on equity, price to earnings, and financial leverage.
Operating leverage and financial leverage are two very critical terms in accounting. Both phenomenons are used by the businesses to increase operating profits and acquire additional assets, respectively.
One thing that often gets ignored is the cost structure of a firm. The cost structure of a business directly impacts all the other measures, including profitability, response to fluctuations, and future growth. Operating leverage is the most authentic way of analyzing the cost structure of any business.
Operating leverage can be defined as the presence of fixed costs in the operating costs of a firm. We all know that the fixed costs remain unaffected by the increase or decrease in revenues. In other words, the operating leverage is the measure of fixed costs and their impact on the EBIT of the firm.
When the company does more investment in the fixed costs, the increase in revenue does not affect the fixed costs. In fact, the fixed cost per unit is decreased, and overall operating profits are increased.
Another inter-related term is the degree of operating leverage. It is often synonymously used for operating leverage. This article will walk you through the degree of operating leverage, its relation with operating leverage, illustrations, and the importance of DOL for a firm.
What Is Degree Of Operating Leverage?
Degree of operating leverage is defined as,
It is a financial ratio that measures the sensitivity of a firm’s EBIT or operating income to its revenues.
The degree of operating leverage shows the change in operating income by the change in the revenues or sales of a company.
Understanding the degree of operating leverage and its impact on the company’s financial health. Let’s break it down to understand the concept
Breaking Down Degree Of Operating Leverage
The companies most commonly calculate the degree of operating leverage to measure the operating risk. The combination of fixed and variable costs gives rises to operating risk.
For instance, if a company has a higher fixed-costs-to-variable-costs ratio, the fixed costs exceed variable costs. As a result, the company faces higher operating risk.
Suppose a company’s degree of operating leverage is higher. In that case, it means that the sensitivity of profit is high to the sales. The higher operating leverage means high operating risks. It also implies that the company will have to drastically grow revenues to maintain profits and cover the fixed costs. The impact of revenue changes will be high on the sales and profits.
Whereas the low measure of DOL shows the high ratio of variable costs. The firm doesn’t need to increase its sales to cover high fixed costs. The low DOL implies low operating risks. Although the companies are not making hundred dollars in profit on each sale. But, they are earning substantial income to cover their costs.
How To Calculate It?
Let’s look at how to calculate the degree of operating leverage.
The most common formula used to calculate the degree of operating leverage is as follow:
Degree Of Operating Leverage = % change in EBIT/% change in Sales
There are many alternative ways of calculating the degree of operating leverage.
- Degree Of Operating Leverage = change in Operating Income/change in Sales
- Degree Of Operating Leverage = Contribution Margin/Operating Income
- Degree Of Operating Leverage = (Sales – Variable Costs )/ (Sales – Variable Costs – Fixed Costs)
- Degree Of Operating Leverage = Contribution Margin Percentage /Operating Margin
Now we will see how to calculate the DOL by example.
Let’s take the example of company ABC and find its DOL. The company’s earnings before interest and tax have increased by 10% from 2020 to 2021. The revenues have also grown during this time by 8%. What will be the operating leverage?
Degree of Operating leverage = 10%/8%
Degree of Operating leverage = 1.25
We will also see the calculation of the degree of operating leverage for an alternative formula that is considered an ideal calculation method.
The most authentic calculation method after percentage change method is the ‘ Sales minus Variable costs’ method.
Degree Of Operating Leverage = Sales – Variable Costs/Sales – Variable Costs – Fixed Costs
Assume there are two companies, Company XYZ and Company LMN.
The revenues of company XYZ are $ 58.6 million, and that of company LMN is $ 32.7 million. The variable costs of company XYZ and company LMN are $25.7 million and $14.56 million. Similarly, the fixed costs of company XYZ and company LMN are $10.9 million and $6.54 million.
The degree of operating leverage for the company XYZ is ($58.6 million – $25.7 million)/ ($58.6 million – $25.7 million – $10.9 million) = 1.50.
The company B’s degree of operating leverage is ($32.7 million – $14.56 million)/ $32.7 million – $14.56 million – $6.54 million) = 1.56.
The results show that if both the firms witness an increase of 30% in their sales, the profit of firm XYZ will increase by 45%, and the profit of firm LMN will increase by 46.8%
|Company XYZ ($ million)||Company LMN ($ million)|
|Sales – Variable Costs||32,864||18,191|
|Sales – Variable Costs – Fixed Costs||21,919||13,605|
|Degree Of Operating Leverage||1.50||1.56|
How Can Degree Of Operating Leverage Impact A Business
By now, we have understood the concept of Dol, its calculation, and examples. Let’s see how the measure can impact the company’s business and financial health.
Instant Insight Of A Firm’s Cost Structure
The DOL of a firm gives an instant look into the cost structure of the firm. The degree of operating leverage has a direct impact on the firm’s profitability. We already discussed that the higher operating leverage implies higher fixed costs.
The impact of the high fixed costs is directly seen in the firm’s ability to manage the revenue fluctuations. Regardless of the sales level, the fixed expenses have to be fulfilled. The high degree of operating leverage reflects the inflexibility in the management of costs and revenues.
For a low degree of operating leverage, the short-term revenue fluctuation doesn’t hurt the company’s profitability to a larger extent.
Investors Can Access The Risk
The other face of DOL is risk in any business. Investors can access the risk profile of a company by analyzing the degree of operating leverage. Undoubtedly, the company’s benefit in the short run from high operating leverages in most cases. But at the same time, such firms are exposed to fluctuations in economic conditions and business cycles.
It wouldn’t be wrong to say that high DOL is the companion of good times. Your profitability is supercharged by high DOL when business conditions and economic circumstances are favorable. But the other perspective of this situation is a lot of costs tied up in fixed assets like real estate, machinery, plants, etc.
And the irony of the situation is that there is very little margin to adjust yourself by cutting fixed costs in times of demand fluctuations and economic downturns. Such businesses tend to have higher volatility of share prices and operating incomes in any economic catastrophe or change in demand pattern.
As a result, investors see such companies as riskier investments, and they remain cautious while making an investment decision.
Degree Of Operating Leverage Vs. Degree Of Combined Leverage
There is another accounting term that closely relates to the degree of operating leverage. It is called the degree of combined leverage. The degree of combined leverage measures the cumulative effect of the degree of operating leverage and financial leverage on the earnings per share. The change is calculated at a given change in the revenues or sales.
The degree of financial leverage is a more mainstream ratio used by the businesses for accessing the sensitivity of earnings per share by the change in the EBIT. Financial leverage is a more relative measure of the company’s debt for acquiring the fixed assets to use. Higher financial leverage represents the high volatility of a company’s earnings per share by a change in EBIT.
The degree of combined leverage gives the optimal level of DOL and DOF for any business.
The formula of the DCL is as follow,
Degree Of Combined Leverage = Change In EPS / Change In Sales = DOL X DFL
Undoubtedly, the degree of financial leverage can guide the investors in investment decisions. It also helps companies to prepare themselves for future events. But the authenticity of the measure might get compromised if it is applied indiscriminately.
The estimation of operating risk by DOL might not be 100% accurate. Still, it gives many useful insights about a company’s operating leverage and ability to handle fluctuations and major economic events.