Operating leverage measures a company's ability to generate profit per dollar of invested capital. It's calculated by dividing a company's operating income...
Operating leverage measures a company's ability to generate profit per dollar of invested capital. It's calculated by dividing a company's operating income by its total capital employed.
Key features of operating leverage:
High operating leverage: A company with high operating leverage relies more heavily on its existing assets for funding, which can lead to higher operating expenses.
Increased profit per unit of capital: Operating leverage helps a company to generate more profit per unit of capital invested.
Higher risk: As operating leverage increases, the company's profit is more sensitive to changes in costs and revenues.
Examples:
A company with a high debt-to-equity ratio and high operating leverage might be more susceptible to rising interest rates that could impact its profit.
A company with a low debt-to-equity ratio and high operating leverage might be able to weather economic downturns better because they have more flexibility in managing their debt costs.
Benefits of high operating leverage:
Increased return on capital
Greater market value due to increased earning potential
Ability to invest in growth opportunities
Risks associated with high operating leverage:
Higher risk of bankruptcy due to increased sensitivity to economic downturns
Higher risk of debt default in periods of financial stress
Difficulty in raising capital at lower interest rates due to increased risk of default