Degree of Operating Leverage Calculator
The degree of operating leverage calculator is a tool that calculates a multiple that rates how much income can change as a consequence of a change in sales. It is also known as operating leverage. In this article, we will learn more about what is operating leverage, its formula, and how to calculate the degree of operating leverage. Furthermore, from an investor's point of view, we will discuss operating leverage vs. financial leverage and use a real example to analyze what the degree of operating leverage tells us.
What is operating leverage?
The degree of operating leverage (DOL) measures how much change in income we can expect as a response to a change in sales. We can say that it is the sales' impact on the company's earnings. In other words, the numerical value of this ratio shows how susceptible the company's Earnings Before Interest and Taxes (EBIT) to its sales.
First, we will start showing the very first formula for calculating the earnings of a company:
Total sales - Total costs = Earnings before interests and taxes (EBIT)
Then, for better understanding, we will expand the term
Total sales - (Variable costs + Fixed costs) = EBIT
Here it is important to remember two points:
- Fixed costs are constant and independent of the level of sales.
- Variable costs increase together with the sales.
Hence, if the cost structure has more prominent
variable costs relative to the
fixed costs, a vast increase in sales will not change EBIT that much. A considerable part of the
total sales will be reduced by the growth in
Contrastly, if the
fixed costs are significant relative to the
variable costs, the EBIT will follow when the sales increase dramatically because those
variable costs will remain low in comparison.
In case this explanation does not fulfill your curiosity about cost structures, you should consider checking out this article about contribution margin in which the authors explain these terms more deeply.
Back to the operating leverage definition: since it considers sales and EBIT, it is already taking into account the effects of the cost structure.
Once obtained, the way to interpret it is by finding out how many times EBIT will be higher or lower as sales will increase or decrease, respectively. For example, for an operating leverage factor equal to 5, it means that if sales increase by 10%, EBIT will increase by 50%. By the way, if you find such a company, do not forget to contact us.
Degree of operating leverage formula
The operating leverage ratio can be obtained directly by a straightforward formula:
Degree of Operating Leverage = Change in EBIT / Change in sales
In most cases, you will have the percentage change of sales and EBIT directly. The company usually provides those values on the quarterly and yearly earnings calls. Basically, you can just put the indicated percentage in our degree of operating leverage calculator, even while the presenter is still talking, and voilà.
In other cases where you want to compare specific periods (for avoiding the seasonality effect, for example), you will need to calculate the particular variation in sales and EBIT. The formulas you will need are:
Change in sales = (Period two sales - Period one sales) / Period one sales
Change in EBIT = (Period two EBIT - Period one EBIT) / Period one EBIT
Ideally, you want to compare the quarter from last year to the quarter of the current year, two consecutive quarters, trailing twelve-month values, or yearly values.
What does the degree of operating leverage say?
If you try different combinations of EBIT values and sales on our smart degree of operating leverage calculator, you will find out that several messages are displayed.
We will discuss each of those situations because it is crucial to understand how to interpret it as much as it is to know the operating leverage factor figure.
For the cases when the operating leverage factor is positive:
Change in EBIT > 0and a
Change in sales > 0mean great news: Your company is selling more, and its earnings are growing. Better you to have a clear return on investment target in case you want to sell. You can also consider reviewing the compounded annual growth rate of the profits to see where your company could be in the next years.
Change in EBIT < 0and a
Change in sales < 0can be the worst combination for a business. It is showing less selling and less profitability. In such a case, it is good for the investor to examine the debt structure, first by reviewing how well the interest is covered. You might want to follow the free cash flow as well to get an understanding of the management decision regarding capital expenses.
For the cases when the operating leverage factor is negative:
Change in EBIT > 0and a
Change in sales < 0means that your company is making more profits by selling less. We recommend you analyze its inventory turnover and cash conversion cycle for a better business understanding.
Change in EBIT < 0and a
Change in sales > 0refers to a decrease in profitability. It is wise to start reviewing the cash generation by operations and the consequently free cash flow. In any case, be wary of all the businesses that have a high operating leverage ratio.
Operating leverage vs. financial leverage
Financial and operating leverage are two of the most critical leverages for a business. Besides, they are related because earnings from operations can be boosted by financing; meanwhile, debt will eventually be paid back by those increased earnings. Thus, investors need to measure the impact of both kinds of leverages.
For the particular case of the financial one, our handy return of invested capital calculator can measure its influence on the business returns. Furthermore, if you are interested to know more about business financing, check the answer to this question: What is the financial ratio interest coverage?
How to calculate the degree of operating leverage?
This section will use the financial data from a real company and put it into our degree of operating leverage calculator.
We will consider two cases: The one in which you already have the percentage change of EBIT and sales, and the other one when you do not have this information. Don't worry; you will see that using the operating leverage formula is not difficult.
For the very first case, we have Synnex, a leading company in the information technology sector, which third quarter results shows the following quarter to quarter changes:
Change in Sales = 4.2 %
Change in EBIT = 0.1%
Then, by using our degree of operating leverage calculator on the left, we get:
Degree of Operating Leverage = 0.02
We can notice that Synnex had a meaningful change in sales of 4.2%. However, it does not impact the EBIT that much. That indicates to us that this company might have huge variable costs relative to its sales. Similarly, we can conclude the same by realizing how little the operating leverage ratio is, at only 0.02.
For the second case, the company we are going to use as an example is Huntington Ingalls Industries (NYSE: HII). HII is an enterprise that manufactures and provides maintenance to ships and submarines of military-grade.
From both reports, we get the following information:
Period one sales = 2,263 millions USD
Period one EBIT = 215 millions USD
Period two sales = 2,027 millions USD
Period two EBIT = 57 millions USD
Then, we use this data as input for our degree of operating leverage calculator:
Change in sales = -10.43%
Change in EBIT = -73.49%
Using the degree of operating leverage formula, we get:
Degree of Operating Leverage = 7.05
We put this example on purpose because it shows us the worst and most confusing scenario for the operating leverage ratio.
As said above, we can verify that a positive operating leverage ratio does not always mean that the company is growing. Actually, it can mean that the business is deteriorating or going through a bad economic cycle like the one from the 2nd quarter of 2020.
However, it is even more important to notice that a decrease of -10.43% in sales meant a decline of -73.49% in EBIT, showing that a considerable reduction in sales can produce a severe decrease in EBIT. This is precisely the risk of the operating leverage factor. A high degree of operating leverage, like the one we got: 7.05, can mean a significant spike in earnings when the sales grow, but also it can mean a severe crash in the profitability of the business when the sales shrink.
Consequently, if you are considering investing in a company with high operating leverage, you should consider how indebted the business is to verify if it will cover its interest payments, even during tough times when EBIT is unusually low.
Finally, it is essential to have a broad understanding of the business and how it performs financially. That's why we highly recommended you to check out our other financial calculators.
In particular, we propose you to check the following valuation methods: P/B ratio , EBITDA multiple DCF method, P/E ratio because as critical as it is to know how the business is doing, the price you are paying for a part of the company is also important.