As the name implies, this calculator is designed to help compute the degree of operating leverage. With this tool, you will be able to estimate how much income may change as a result of a sales change. It is referred to as operating leverage in finance. In this article, we’re going to review this calculator to help you understand how it works.
But this is not the only thing you can learn here. In addition, you can find out more about operating leverage and discover the difference between this metric and financial leverage. Moreover, you can learn how the degree of operating leverage is calculated using the appropriate formula. We will also provide a real-life example of this calculation that can come in handy when analyzing the degree of operating leverage.
Operating Leverage: What Is It?
Operating leverage is a measure of how the percentage change in sales affects the percentage change in operating income. It is a measure of the efficiency with which a company uses its own capital to generate profits. Operating leverage is a measure that assesses how much an increase or decrease in revenue will affect operating income. For example, if a company has an operating leverage ratio of 2, then for every dollar increase in revenue, there would be two dollars of profit.
As a matter of fact, it measures how much profit is generated for each dollar invested in assets, and it can be interpreted as how much profit can be generated on an additional dollar of assets. The operating leverage ratio is calculated by dividing the net operating income by the total assets.
The higher the operating leverage ratio, the more efficient a company’s use of assets is, and thus, the more profitable it will be if it invests in new assets. For instance, if Company A has an operating leverage ratio of 5 and Company B has an operating leverage ratio of 2, then Company A will have twice as much profit.
Earnings before Interest and Taxes (EBIT)
As far as the operating leverage is concerned, this ratio tells us how susceptible the EBIT of the company is to its sales. That’s why we will first see how to calculate the earnings of a company. All you need to do is use this simple equation:
Earnings before interest and taxes (EBIT) = Total sales – Total costs
If we expand the Total Costs, the formula is as follows:
EBIT = Total sales – (Variable costs + Fixed costs)
Once you have calculated the EBIT of the company, you will have a better idea of the operating leverage, as it considers EBIT and sales. This will help you determine how many times EBIT is going to be lower or higher as sales go up or down respectively.
Financial Leverage vs. Operating Leverage: What’s the Difference between Operating Leverage and Financial Leverage
Operating leverage is the amount of debt a company has and the amount of equity financing it has. Financial leverage is the use of debt to finance an investment.
If a company has more debt than equity financing, it is said to have high operating leverage. This means that the company can take on more debt because its assets are worth more than its liabilities. That can be dangerous for the company if it’s not careful and has too much debt, but it also means that it can generate more revenue with less capital because they have less risk in their business.
Financial leverage is the use of borrowed funds to purchase an asset. The asset can be tangible, such as a building, or intangible, such as a patent. The borrowed funds are typically used to increase the return on investment or return on equity.
The following are some of the ways that financial leverage can be used:
- Buy an asset that might not otherwise be affordable.
- Spread out the risk of owning an asset.
- Make investments in assets with long-term returns.
- Take advantage of tax benefits and depreciation.
Just like operating leverage, financial leverage is extremely important for businesses. These leverages are related since financing can help increase earnings from operations. In the meantime, those increased earnings will cause debt to be paid off. That’s why investors should gauge the influence of each type of leverage.
How to Calculate the Degree of Operating Leverage
When calculating the degree of operating leverage, you should have information on the percentage change of sales and EBIT. Once you gather this information, calculate the degree of operating leverage using the formula below:
Degree of Operating Leverage = Change in EBIT / Change in Sales
For example, if the change in sales is 3% while the change in EBIT is 2%, then the Degree of Operating Leverage would be 0.667.
How to Interpret the Degree of Operating Leverage – What Does It Say?
When trying various combinations of sales and EBIT on our calculator, you’ll get different values displayed. It’s important to know how to interpret them, which is why we’re going to scrutinize four different situations. Let’s check them out!
1) Positive Operating Leverage Factor
- Change in sales > 0 while the change in EBIT > 0: That’s great news. This means your enterprise sells more, which makes earnings grow. If you’re interested in selling, make sure your ROI target is clear for the best results.
- Change in sales < 0 while the change in EBIT < 0: This combination can be very bad for businesses. It indicates a decrease in profitability and less selling. In this case, you should consider examining the debt structure. Review the interest and check how well it’s covered.
2) Negative Operating Leverage Factor
- Change in sales < 0 while the change in EBIT > 0: This tells you that you sell less, thereby making more profits. You are advised to analyze the cash conversion cycle and inventory turnover of your company.
- Change in sales > 0 while the change in EBIT < 0: It’s showing less profitability. In this case, it is recommended to review the cash generation for each operation as well as the free cash flow.