Monday, December 3, 2012

Understanding the Degree of Operating Leverage

The operating, or “fundamental,” risk of a company is the risk a company faces because of the business it is in.  For example, the profits a firm makes depend on the demand for its goods and the costs of producing the goods, so it inherently faces the risk that costs could increase and/or demand could fall, which would affect the profits of the firm.
Operating risks result from the investment decision of the firm, and are separate from financial risk, which results from the financing decision.   One way to measure operating risk is through activity analysis, which studies how the operating activities of the company generate profits, see below.
Fundamental Risk and Beta
 A different measure of risk, beta, is based on stock returns.  It measures the sensitivity of a stock’s return to the market as a whole.  In its pure form, it does not pay attention to fundamentals.  However, people have developed the concept of a “fundamental beta” which takes into account information such as operating and financial risk.  One argument in favor of this approach is that beta typically is calculated using historical data, while fundamentals provide information about the future performance of a firm. 
So one question you can ask is whether beta reflects fundamental risk.  For example, do firms with high operating risk have high betas, or more broadly, if there is a systematic relationship between beta and fundamentals.
Operating Risk
 Operating risk in “Activity Analysis” is measured by the “Degree of Operating Leverage.”  The ideas underlying this measure can be developed as follows.  From the firm’s financial statements we can first estimate a firm’s Earnings Before Interest and Taxes (EBIT) which provides a measure of the operating income for a firm.  One measure of operating risk is the Degree of Operating Leverage (DOL) defined by
Degree of Operating Leverage (DOL) = % Change EBIT/% Change in sales revenue
This definition is related to the concept of elasticity in economics: it measures the percentage change of one variable due to a percentage change in another.  So here, operating risk is defined as the elasticity of a firm’s EBIT to Sales Revenue. 
Why is this measure of operating risk?  Because it tells you how sensitive profits are to changes in sales.  If they are very sensitive, then it could mean, for example, that the firm has high fixed costs, so it is more exposed to a downturn in sales than a firm with low fixed costs.  Numerically, consider a firm that has a fixed cost of $50m and then a variable cost of $1 per unit.  If it sells 100m units at $2 each, it has a profit of $50m (200m in revenue minus 100m in variable costs minus 50m in fixed costs).  If sales drop by 10% to 90m units, profit drops to 180m – 90m – 50m = 40m, which is a 20% drop in profit.  If the same firm had zero fixed costs, its profit would drop by 10% if sales dropped by 10%.
In the lesson, you will learn how to calculate the DOL for Wal-Mart and Intel.  Then, you will compare them to the betas, and see if a higher DOL is associated with a higher beta.  At the end of the lesson is an exercise that lets you conduct a more systematic analysis of the relationship between operating risk and beta.
To access the lesson, from the FSA module, simply select it from the Lessons menu:

71 comments:

  1. The information which you people are given are really superb..!!!
    66666q

    ReplyDelete
  2. I am so excited while I read all the comments.chatpaway

    ReplyDelete
  3. Keep posting the articles,useful to every one.babblein

    ReplyDelete
  4. Its really informative tutorial. Thank you for this tutorial .dhc9

    ReplyDelete
  5. its really informative tutorial. Thank you for this tutorial .ecolenepal

    ReplyDelete
  6. Not only to read need to spreed every one.draftcowboys

    ReplyDelete
  7. Thank you for this tutorial.its really informative tutorial.laurahardie

    ReplyDelete
  8. all the words in simple way every one should understand easily.
    intiraymi2013

    ReplyDelete
  9. Thank you for this guidance.its really informative for all..
    jerseyjoesbt

    ReplyDelete
  10. Very useful comments are posted and everybody like this comments
    stylewheel

    ReplyDelete
  11. Not only to read the post, need to spreed every one
    teleconnectga

    ReplyDelete
  12. Most of the post and comments are related my blog
    wikinotizie

    ReplyDelete
  13. All the words are simple and every one should understand easily
    omarsabet

    ReplyDelete
  14. Need to implement all the information's in my blog
    paarsimaan

    ReplyDelete
  15. This Comment is very useful and every one should follow this
    deborahzandonna

    ReplyDelete
  16. Keep posting this articles and useful for every one
    unsecretbiengarde

    ReplyDelete
  17. Peoples are giving the wonderful thoughts for all comments
    NakedNutritionNetwork

    ReplyDelete
  18. Thanks for giving the good informative tutorial
    KdOperSonNaLise

    ReplyDelete
  19. Thank you for this guidance.its really informative for all
    menurepairmen

    ReplyDelete
  20. The information's are really good and peoples are given wonderful comments for all the post
    forgrandma

    ReplyDelete
  21. All the post are very useful to implement in our life
    thepalacesliemahotel

    ReplyDelete
  22. Some articles are related in our life,so nice
    nearing-zero

    ReplyDelete
  23. The words are so simple and easy to understand
    provencesmartvalley

    ReplyDelete
  24. Nice to read all post and more innovative
    wkraj

    ReplyDelete
  25. The information's are useful for every people
    justgenesandtease

    ReplyDelete
  26. Peoples are giving a really nice comments for all the article
    soulwaterpublishing

    ReplyDelete
  27. All the post are good and the peoples are giving nice comment for all post
    egwa-aevv

    ReplyDelete
  28. Really nice,every one should like all the comments
    rsdconcrete

    ReplyDelete
  29. Very useful comments are posted and everybody like this comments
    heqinghotel

    ReplyDelete
  30. Not only to read the post, need to spreed every one
    mikissecret

    ReplyDelete
  31. Most of the post and comments are related my blog
    spenglerfoxbelfast

    ReplyDelete
  32. All the words are simple and every one should understand easily
    CumbreDeltaNgo

    ReplyDelete
  33. Need to implement all the information's in my blog
    Mmunud

    ReplyDelete
  34. This Comment is very useful and every one should follow this
    jugprom

    ReplyDelete
  35. Keep posting this articles and useful for every one
    tics-mex

    ReplyDelete
  36. Peoples are giving the wonderful thoughts for all comments
    hftexpertsforum

    ReplyDelete
  37. So many peoples are given the wonderful comments for this articles
    okuadamol

    ReplyDelete

  38. First is to thank you for all this informative posts you give us for free; i bet all of us are happy.
    Such a great idea of yours! You have been a big help for me. Thanks a lot. more post for interesting topic. Great!

    SAP training in Chennai

    ReplyDelete
  39. I came across this post when I was searching for related information on Yahoo search engine,SAP Simple Finance Training in Hyderabad

    ReplyDelete
  40. I just read your comment such a very nice. Thank you for posting this blog,Our oracle fusion low price of fee for on-line coaching.
    Oracle fusion financials training

    ReplyDelete
  41. Thanks for sharing the useful information and good points were stated in the blog which is very informative and for the further information visit our site
    Oracle Fusion Financials Training

    ReplyDelete
  42. hi,
    This is very interesting topic.Thanks for sharing such a nice topic.
    http://crm.fueledbysleep.com/no-code/the-new-features-of-dynamics-crm-2016-how-to-use-them/

    ReplyDelete
  43. hi,this is a very valuable topic.
    Thanks for giving such a topic.
    keep posting this topic.
    oracle fusion SCM online training

    ReplyDelete
  44. Hi,
    this is very interesting topic. Thanks for sharing such a nice topic.
    oracle fusion HCM training.

    ReplyDelete
  45. I love reading through your blog, I wanted to leave a little comment to support you and wish you a good continuation. Wish you best of luck for all your best efforts. I want to share some information, we provide outsource data entry services in all over the world.
    Product Description Writing Services In India

    ReplyDelete
  46. This comment has been removed by the author.

    ReplyDelete
  47. Thank you for sharing such a nice and interesting blog with us. I have seen that all will say the same thing repeatedly. But in your blog, I had a chance to get some useful and unique information.

    Oracle Fusion HCM Online Training

    ReplyDelete
  48. I like your writing style, it is very clear to understand the concept well; I hope you keep your blog as updated.
    Best Photoshop Training Institute in Chennai | No.1 Adobe Photoshop Training Institute in Velachery

    ReplyDelete
  49. Extraordinary blog. you put Good stuff. All the themes were clarified briefly.Thanks for sharing that post.Keep in blogging…
    Web Designing Training Institute in Chennai | Web Designing Training Institute in Velachery

    ReplyDelete
  50. I would like to thank you for the efforts you have made in writing this article. I am hoping the same best work from you in the future as well.

    Oracle Taleo Online Training

    ReplyDelete
  51. Thank you for taking the time and sharing this information with us. It was indeed very helpful and insightful while being straight forward and to the point.
    Java Training in Chennai
    Java course in Chennai
    Angularjs Training in Chennai
    Selenium Training in Chennai
    German Classes in Chennai
    Java Training in Anna Nagar
    Java Training in Velachery

    ReplyDelete
  52. brilliant web website online, outstanding comments that i can undertake. Im upsetting adopt and might follow to my contemporary process as a pet sitter, that is extremely courteous, but I yearning to toting going on cross beforehand. Regards. same day online payday loans direct lenders

    ReplyDelete
  53. Thanks for another excellent post. Where else could anybody get that type of info in such an ideal way of writing? In my opinion, my seeking has ended now. financial news for today

    ReplyDelete
  54. Thank you for sharing such a nice and interesting blog and really very helpful article

    Oracle Fusion HCM Online Training

    ReplyDelete
  55. Awesome post.. Really you are done a wonderful job.thank for sharing such a wonderful information with us..please keep on updating..
    PCB Designing Training Institute in Chennai | PCB Training Center in Velachery | PCB Design Courses in Thiruvanmiyur

    ReplyDelete