An operating leverage is a company’s EBIT (earnings before taxes and financial operations) sensitivity to changes of sales. As the sensitivity is measured to operating income (close to EBIT), the financial leverage does not take a part in here.
Operating leverage of the company depends on fixed costs to the sales ratio. If fixed costs consist a large part of total costs and the profitability margins are low, then the decrease in sales would have a critical impact to company’s profit.
Higher operating leverage means company’s operating income is more sensitive to impacts of the market, that’s why investments in such companies are riskier. Company’s income also will be more volatile if profit margin is very low, then any decreases in sales together with high operating and financial leverage may immediately turn to a huge loss. In other hand such riskier investments also will show very good results when economy will rise.
Each manager of the company, especially if the company works in cyclical business, as manufacturing of cars, should try to make company more stable and lower the operating leverage. There are many instruments for that: temporary employment agreements, machinery rent instead of acquisition, flexible rent agreements for property, flexible contracts with suppliers, low inventory etc.
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