OPERATING LEVERAGE

Definition
The degree to which an investor or business is utilizing borrowed money. Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future. Leverage is not always bad, however; it can increase the shareholders' return on investment and often there are tax advantages associated with borrowing.

Formula
Operating Leverage = [Quantity x (Price Variable Cost per Unit)] / Quantity x (Price Variable Cost per Unit) - Fixed Operating Cost

Example
Let's assume Company XYZ sold 1,000,000 widgets for $12 each. It has $10,000,000 of fixed costs (equipment, salaried personnel, etc.). It only costs $0.10 per unit to make each widget.

Solution
Using this information and the formula above, we can calculate that Company XYZ's operating leverage is: Operating Leverage = [1,000,000 x ($12 - $0.10)] / 1,000,000 x ($12 - $0.10) - $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626% This means that a 10% increase in revenues should yield a 62.6% increase in operating income

Advantages
Helps in designing appropriate capital structure of the firm Indicate market price of the share Enable understanding of how EPS would change given the certain change in EBIT