Operating Leverage: The Optical Reversal

In simple words, operating leverage is convenient for a company to grow its revenue without (or less) an increase in its fixed cost

Asset heavy companies who have high fixed cost like, depreciation or rent, generally are eligible to have operating leverage

For these firms, if they want to grow their revenue, they also have to spend more at variable cost, but their fixed cost will remain the same

That means, it will lead to fast revenue growth compared to the growth of cost and will lead to fast profit growth compared to revenue growth

Refer to our earlier post regarding Operating leverage:

Operating Leverage: The basic

Operating Leverage: A Framework for Anticipating Changes in Earnings

But it is not a thumb rule that companies with operating leverage eligibility always report higher growth of operating profit to compare to revenue growth due to operating leverage, and things don’t always happen as theory

Sometimes, there are special situations when companies who have operating leverage but reported less or no growth in operating profit with growth in revenue

Special Situations

Special situation 1

Here we have an example of Jindal Steel, which is Asset heavy company, has depreciation as a fixed cost, and hence, it is eligible for operating leverage (as it can increase its revenue on the same depreciation – fixed cost)

As we see here, the company’s revenue is increasing by 39%, and as per operating leverage (in a normal situation), operating profit should increase by more than 39%

But here, the company is having a large increase in its fixed cost – depreciation; which is making an operating profit to fall by 3%

Generally (in a normal situation), variable cost increase by the same or almost the same amount as revenue, but as fixed cost like depreciation remain the same, companies have high growth of operating profit

Special situation 2

Let’s say there is a company who has operating leverage and enjoys high operating profit in upswings

And let’s say the company is going to acquire another company, who has decent revenue but have a large loss on its P&L

In this situation, when the company make its consolidated balance sheet, the revenue increase will be there of decent growth, but due to consolidation, parent companies operating profit growth will be eaten away by that huge loss of acquired company

Hence, here too the company will be there with lower or no growth in operating profit

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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