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Definition of operating leverage

Operating Leverage Image 1

operating leverage

A relatively small percent increase or decrease in
sales volume that causes a much larger percent increase or decrease in
profit because fixed expenses do not change with small changes in sales
volume. Sales volume changes have a lever effect on profit. This effect
should be called sales volume leverage, but in practice it is called operating
leverage.
operating liabilities
The short-term liabilities generated by the operating
(profit-making) activities of a business. Most businesses have three types
of operating liabilities: accounts payable from inventory purchases and
from incurring expenses, accrued expenses payable for unpaid expenses,
and income tax payable. These short-term liabilities of a business are
non-interest-bearing, although if not paid on time a business may be
assessed a late-payment penalty that is in the nature of an interest
charge.


operating leverage

Degree to which costs are fixed.


Operating leverage

Fixed operating costs, so-called because they accentuate variations in profits.


operating leverage

the proportionate relationship between
a company’s variable and fixed costs



Related Terms:

degree of operating leverage

a factor that indicates how a percentage change in sales, from the existing or current
level, will affect company profits; it is calculated as contribution
margin divided by net income; it is equal to (1 - margin of safety percentage)


degree of operating leverage (DOL)

Percentage change in profits given a 1 percent change in sales.



breakeven point

The annual sales volume level at which total contribution
margin equals total annual fixed expenses. The breakeven point is only a
point of reference, not the goal of a business, of course. It is computed by
dividing total fixed expenses by unit margin. The breakeven point is
quite useful in analyzing profit behavior and operating leverage. Also, it
gives manager a good point of reference for setting sales goals and
understanding the consequences of incurring fixed costs for a period.


Leverage

The relationship between interest bearing debt and equity in a company(financial leverage) or the effect of fixed expense on after tax earnings(operating leverage).


Operating Leverage Image 2

margin of safety

the excess of the budgeted or actual sales
of a company over its breakeven point; it can be calculated
in units or dollars or as a percentage; it is equal to
(1 - degree of operating leverage)


Operating risk

The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is
created by operating leverage. Also called business risk.


Annual fund operating expenses

For investment companies, the management fee and "other expenses,"
including the expenses for maintaining shareholder records, providing shareholders with financial statements,
and providing custodial and accounting services. For 12b-1 funds, selling and marketing costs are included.


cash flow from operating activities, or cash flow from profit

This equals the cash inflow from sales during the period minus the cash
outflow for expenses during the period. Keep in mind that to measure
net income, generally accepted accounting principles require the use of
accrual-basis accounting. Starting with the amount of accrual-basis net
income, adjustments are made for changes in accounts receivable,
inventories, prepaid expenses, and operating liabilities—and depreciation
expense is added back (as well as any other noncash outlay
expense)—to arrive at cash flow from profit, which is formally labeled
cash flow from operating activities in the externally reported statement
of cash flows.


Cash Flow Provided by Operating Activities

With some exceptions, the cash effects of transactions
that enter into the determination of net income, such as cash receipts from sales of goods
and services and cash payments to suppliers and employees for acquisitions of inventory and
expenses.


Debt leverage

The amplification of the return earned on equity when an investment or firm is financed
partially with borrowed money.


Financial leverage

Use of debt to increase the expected return on equity. Financial leverage is measured by
the ratio of debt to debt plus equity.


financial leverage

The equity (ownership) capital of a business can serve
as the basis for securing debt capital (borrowing money). In this way, a
business increases the total capital available to invest in its assets and
can make more sales and more profit. The strategy is to earn operating
profit, or earnings before interest and income tax (EBIT), on the capital
supplied from debt that is more than the interest paid on the debt capital.
A financial leverage gain equals the EBIT earned on debt capital
minus the interest on the debt. A financial leverage gain augments earnings
on equity capital. A business must earn a rate of return on its assets
(ROA) that is greater than the interest rate on its debt to make a financial
leverage gain. If the spread between its ROA and interest rate is unfavorable,
a business suffers a financial leverage loss.


financial leverage

Debt financing amplifies the effects of changes in operating income on the returns to stockholders.


Operating Leverage Image 3

Financial leverage clientele

A group of investors who have a preference for investing in firms that adhere to
a particular financial leverage policy.


Financial leverage ratios

Related: capitalization ratios.



Highly leveraged transaction (HLT)

Bank loan to a highly leveraged firm.


Homemade leverage

Idea that as long as individuals borrow (or lend) on the same terms as the firm, they can
duplicate the affects of corporate leverage on their own. Thus, if levered firms are priced too high, rational
investors will simply borrow on personal accounts to buy shares in unlevered firms.


Leverage

The use of debt financing.


Leverage

he use of debt financing.


Leverage clientele

A group of shareholders who, because of their personal leverage, seek to invest in
corporations that maintain a compatible degree of corporate leverage.


Leverage ratios

Measures of the relative contribution of stockholders and creditors, and of the firm's ability
to pay financing charges. Value of firm's debt to the total value of the firm.


Leverage rebalancing

Making transactions to adjust (rebalance) a firm's leverage ratio back to its target.


Leveraged beta

The beta of a leveraged required return; that is, the beta as adjusted for the degree of
leverage in the firm's capital structure.


Leveraged buyout

The purchase of one business entity by another, largely using borrowed
funds. The borrowings are typically paid off through the future cash flow of
the purchased entity.


Operating Leverage Image 4

Leveraged buyout (LBO)

A transaction used for taking a public corporation private financed through the use
of debt funds: bank loans and bonds. Because of the large amount of debt relative to equity in the new
corporation, the bonds are typically rated below investment grade, properly referred to as high-yield bonds or
junk bonds. Investors can participate in an LBO through either the purchase of the debt (i.e., purchase of the
bonds or participation in the bank loan) or the purchase of equity through an LBO fund that specializes in
such investments.



leveraged buyout (LBO)

Acquisition of the firm by a private group using substantial borrowed funds.


Leveraged equity

Stock in a firm that relies on financial leverage. Holders of leveraged equity face the
benefits and costs of using debt.


Leveraged lease

A lease arrangement under which the lessor borrows a large proportion of the funds needed
to purchase the asset and grants the lender a lien on the assets and a pledge of the lease payments to secure the
borrowing.


Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.


Leveraged portfolio

A portfolio that includes risky assets purchased with funds borrowed.


Leveraged required return

The required return on an investment when the investment is financed partially by debt.


Net benefit to leverage factor

A linear approximation of a factor, T*, that enables one to operationalize the
total impact of leverage on firm value in the capital market imperfections view of capital structure.


Net operating losses

Losses that a firm can take advantage of to reduce taxes.


Net operating margin

The ratio of net operating income to net sales.


operating activities

Includes all the sales and expense activities of a business.
But the term is very broad and inclusive; it is used to embrace all
types of activities engaged in by profit-motivated entities toward the
objective of earning profit. A bank, for instance, earns net income not
from sales revenue but from loaning money on which it receives interest
income. Making loans is the main revenue operating activity of banks.


operating budget

a budget expressed in both units and dollars


Operating cash flow

Earnings before depreciation minus taxes. It measures the cash generated from
operations, not counting capital spending or working capital requirements.


operating cash flow

See cash flow from operating activities.


Operating Cash Flow

Income available after the payment of taxes, plus the value of the
non-cash expenses


Operating cycle

The average time intervening between the acquisition of materials or services and the final
cash realization from those acquisitions.


Operating Earnings

A term frequently used to describe earnings after the removal of the
effects of nonrecurring or nonoperating items.


Operating expense

Any expense associated with the general, sales, and administrative
functions of a business.


OPERATING EXPENSES

The total amount that was spent to run a company this year.


Operating Expenses

The amount of money the company must spend on overhead, distribution, taxes, underwriting the risk and servicing the policy. It is a factor in calculating premium rates.


Operating exposure

Degree to which exchange rate changes, in combination with price changes, will alter a
company's future operating cash flows.


Operating income

The net income of a business, less the impact of any financial activity,
such as interest expense or investment income, as well as taxes and extraordinary
items.


Operating Income

A measure of results produced by the core operations of a firm. It is common
for both recurring and nonrecurring items that are associated with operations to be included
in this measure. operating income is typically found in multistep income statements and is a pretax
measure.


Operating lease

Short-term, cancelable lease. A type of lease in which the period of contract is less than the
life of the equipment and the lessor pays all maintenance and servicing costs.


Operating lease

The rental of an asset from a lessor, but not under terms that would
qualify it as a capital lease.


Operating Lease

One where the risks and benefits, as well as ownership, stays with the lessor.


Operating Line of Credit

A bank's commitment to make loans to a particular borrower up to a specified maximum for a specified period, usually one year.


Operating Loan

A loan advanced under an operating line of credit.


Operating profit

The profit made by the business for an accounting period, equal to gross profit less selling, finance, administration etc. expenses, but before deducting interest or taxation.


operating profit

See earnings before interest and income tax (EBIT).


Operating profit margin

The ratio of operating margin to net sales.


operating risk (business risk)

Risk in firm’s operating income.


Short-run operating activities

Events and decisions concerning the short-term finance of a firm, such as
how much inventory to order and whether to offer cash terms or credit terms to customers.


Unleveraged beta

The beta of an unleveraged required return (i.e. no debt) on an investment when the
investment is financed entirely by equity.


Unleveraged required return

The required return on an investment when the investment is financed entirely
by equity (i.e. no debt).


return on assets (ROA)

Although there is no single uniform practice for
calculating this ratio, generally it equals operating profit (before interest
and income tax) for a year divided by the total assets that are used to
generate the profit. ROA is the key ratio to test whether a business is
earning enough on its assets to cover its cost of capital. ROA is used for
determining financial leverage gain (or loss).



 

 

 

 

 

 

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