Why are Corporations Hoarding Trillions in Cash?
February 7, 2025
Bankruptcy is one of the natural states which a company may find itself in. Entrepreneurship is primarily about taking risks. When companies take risks, some of them succeed, whereas others fail. Hence failure is a natural part of the business. However, many critics of bankruptcy laws believe that there isn’t a need for an elaborate […]
What is the Wirecard Scandal all about and Why it is a Wakeup Call for Whistleblowers Anyone who has been following financial and business news over the last couple of years would have heard about Wirecard, the embattled German payments firm that had to file for bankruptcy after serious and humungous frauds were uncovered leading […]
How Modern Decision Makers Have to Confront Present Shock and Information Overload We live in times when Information Overload is getting the better of cognitive abilities to absorb and process the needed data and information to make informed decisions. In addition, the Digital Age has also engendered the Present Shock of Virality and Instant Gratification […]
Geopolitics, Economics, and Geoeconomics In the evolving global trading and economic system, firms and corporates are impacted as much by the economic policies of nations as they are by the geopolitical and foreign policies. In other words, any global firm wishing to do business in the international sphere has to be cognizant of both the […]
In the previous article, we have already come across some of the reasons why the government should not encourage funding of stadiums that are to be used by private franchises. We have already seen that the entire mechanism of government funding ends up being a regressive tax on the citizens of a particular city who […]
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 *