Current Ratio – Formula, Meaning, Assumptions and Interpretations
The current ratio is the most popularly used metric to gauge the short term solvency of a company. This article provides the details about this ratio. Formula Current Ratio = Current Assets / Current Liabilities Meaning Current ratio measures the current assets of the company in comparison to its current liabilities. This means that the…
What are Common Size Statements ?
Common size statements are not financial ratios. Rather they are a way of presenting financial statements that makes them more suitable for analysis. However, analysts always use them in conjunction with ratio analysis. In fact, financial analysts use common size statements as the starting point to help them dig deeper. Common size statements tell them…
Introduction to Cash Flow Ratios
Once upon a time, investors and analysts used to believe in ratios that have been calculated based on the earnings that the company has stated in the Income Statement. Alas! That was once upon a time. Of late, there have been a huge number of frauds and malpractices that have come to the fore. All…
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.
Your email address will not be published. Required fields are marked *
