“Operating leverage measures the change in operating profit as a function of the change in sales.” To check about operating leverage in a company one can check the ratio of it’s fixed to variable cost. Fixed costs are not affected by company’s sales. So if company’s sales are low, then fixed costs will dampen profit. But if sales are higher than profit will be higher too. Generally companies with higher fixed assets to total assets ratio will have higher fixed cost too. So there’s a positive correlation between fixed assets to total assets ratio and operating leverage.
Sales Growth
Sales growth forecast is done by using economic growth, industry growth. Industry growth follows an S-curve and analysts make mistake in the middle of the S-curve. To assess industry size, number of potential customers can be multiplied by revenue per customer. Mergers and acquisitions also need to be carefully analyzed as it can change the nature of company’s operating leverage. Also evidence shows that it is challenging to create value by doing mergers and acquisitions. Increasing market share can also result in increasing profitability as there is a positive correlation between market share and profitability.
Sales growth is an important value driver because it is the source of cash and affects value factors. If company is earning more than cost of capital then only sales growth creates value otherwise it destroys value.
Level of operating profit margin at which a company is earning its cost of capital is threshold margin. Company with higher capital intensity requires a higher operating profit margin to break even in terms of economic value. So threshold margin can be used to make connection between sales growth, profit and value creation.
Value Factors
Operating profit margin can vary based on sales. To sort out cause and effect of changes, value factors can be considered.
Volume – Volume changes lead to sales changes and thus can influence operating profit margin by operating leverage and economies of scale.
Price and Mix – Change in price can impact margins i.e. if a company sells same units at higher prices then margin will rise and vice versa. Warren Buffet argued that “the single most important decision in evaluating a business is pricing power.” To assess pricing power, price elasticity can be used.
Operating Leverage – Preproduction costs i.e. investments done before generating sales and profits are capitalized on balance sheet and are depreciated later on. These costs lower operating profit margin in short run. But as the sales rise, operating margin increases because the incremental investment is small. Capacity utilization can be used to assess operating leverage.
Economies of Scale – Economies of scale is that a company is able to lower its cost per unit by producing higher quantities. Economies of scale lead to greater efficiency as volume increases.
Cost Efficiencies – These efficiencies can come in two ways i.e. company either reducing cost within an activity or it can reconfigure its activities.
Financial Leverage
Debt increases the volatility of earnings because interest has to be paid. Adding debt creates more volatility in earnings. Higher debt to total capital ratio is consistent with higher financial leverage but holding substantial amount of cash distorts this relationship.
Credit ratings are a proxy for financial leverage. Companies with higher ratings generally have low debt, higher margins, and good interest expense coverage ratio.
Threshold and Incremental Threshold Operating Profit Margin
Threshold margin is the level of operating profit margin at which the company earns its cost of capital. If the company is earning more than its cost of capital then it is creating value. Incremental threshold margin captures the margin required on new sales.
The Fundamental Mindset 