Operating Leverage

 
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Operating leverage is the degree to which fixed costs exist in a company's cost structure. Generally speaking, operating leverage is fixed costs divided by total costs.

Operating leverage is important to the investment community because it is an indicator of the quality of earnings of a firm.

There are three measures of operating leverage:

1. Fixed costs to total costs: An increase in the ratio of fixed costs to total costs may indicate lower earnings quality because higher fixed costs may result in greater earnings instability.

2. Percentage change in operating income to the percentage change in sales: An increase in the ratio of the percentage change in operating income to the percentage change in sales may indicate lower earnings quality because higher fixed costs may result in greater earnings instability.

3. Net income to fixed costs: An decrease in the ratio of net income to fixed costs may indicate lower earnings quality because higher fixed costs may result in greater earnings instability.

A higher percentage of variable costs to total costs indicates greater earnings stability since variable costs can change more easily than fixed costs to meet a decline in sales. Moreover, a company with a high break even point is more vulnerable to economic declines.

External Links: Operating Leverage and Degree of Operating Leverage

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