What ratios would you use to evaluate operating leverage for a firm?
Operating leverage measures the extent to which an additional dollar of sales increases the firm's net income. The greater the increase in Net Income for a given increase in sales, the greater the firm's operating leverage. For example, if a firm only had variable costs, each additional dollar of sales would be expected to generate additional income equal to the existing Net Income/Sales ratio for the firm. Conversely, if the firm had only fixed costs, an additional dollar of sales would generate an additional dollar of net income (assuming the firm did not pay taxes). Thus, understanding a firm's operating leverage requires estimating how much of the firm's costs are fixed and how much are variable. This concept is complicated by the fact that in the long run most costs are variable.
While there is no single measure of a firm's operating leverage, several ratios can help evaluate a firm's operating leverage and compare it with those of other firms. Information from financial statements is typically crude and only gives a rough approximation of operating leverage. A more thorough analysis requires specific cost-accounting information from within the firm. Changes in net income relative to changes in sales, or return on sales ratios relative to sales volume, provide rough guides of operating leverage. Asset ratios, such as (Net PPE/Sales) or (Capital Expenditures/Sales), can also provide a way of assessing how much of a firm's production costs are fixed. More detailed information, including (salary expense of production workers/Sales) and (raw material expenses/Sales), can provide a finer picture of a firm's operating leverage. Estimating a firm's operating leverage requires understanding which of the firm's costs are fixed and which are variable. The ratios mentioned above are very general. Depending on the specific firm and industry, other ratios may be more useful.
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