The Operating Leverage ratio explained.

The Operating Leverage is a financial efficiency ratio not specifically a “profitability ratio”. The OL is a ratio used to measure how operating income is affected by how fixed & variable costs intertwine with sales volume. Operating leverage and profitability are positively related as profits are determined by the fixed and variable costs associated with generating that revenue.

The ratio measures how much revenue growth converts into the growth of operating income.

I believe operating leverage is one of the most underated ways to look at a business, in particular growth or early-stage companies. When it is used it can often be misunderstood in terms of how it can affect a company and the greater opportunity of its potential margins in the future.

A business that minimizes fixed costs can increase its profits without making any changes to the selling price or volume sold. A business with higher leverage may produce lower profits since the break-even point becomes higher.

High Operating Leverage means a business can earn larger profits after its break-even point due to minimal variable costs and known fixed costs. A higher volume of sales is needed to cover the higher fixed costs.

Low Operating Leverage means a business has a higher proportion of variable costs and lower fixed costs so for an incremental growth in sales to occur its costs will go along with it. Low is not necessarily bad as it means a business does not need higher volume to make a profit and cover its lower fixed costs.

Fixed Costs: Expenses that are not dependent on the level of goods or services produced by the business such as rent which is reoccurring regardless of sales.

Variable Costs: Expenses that change as the company’s sales and volume change. Costs needed to fulfill its revenue such as packaging costs increase with every order.

What is the Operating Leverage formula?

There are several different ways to determine the operating leverage however I have found the below to be the most useful. The standard (Fixed Costs ÷ Total Costs) is too generic so I prefer the below. The other methods require an in-depth breakdown of a company’s variable and fixed costs or even unit costs which may be hard to accurately decipher.

Degree of Operating Leverage (DOL)

• % change refers to the year-over-year change (YoY) and can be calculated by dividing the current year balance by the prior year balance and then subtracting by 1.

As a private investor, the degree of operating leverage formula is a good way to give you the information you need with out getting to complex.

How to use the Operating Leverage ratio?

In a simple example, let’s look at a company and determine what sort of operating leverage it has.

Income Statement	2022	2023
Sales Revenue	$61.5 million	$78 million
Operating Income	$19.3 million	$21 million

Step 1 Calculate the change in Operating Income from 2022-2023 which is:

($78m ÷ $61.5m) – 1 = 26.82%

Step 2 Calculate the change in Sales Revenue from 2022-2023 which is:

($21m ÷ $19.3m) – 1 = 8.80%

Step 3 The final calculation expresses this change as our ratio:

26.82% ÷ 8.80% = 3.04

An operating leverage of 3.04 means for every 10% increase in the company’s sales revenue, operating income is expected to grow by 30.4%. (10% x 3.04) = 30.4% OR (1% increase in sales = 3.04% increase in operating income).

In “theory” if this company doubles its sales revenue by 100% we can imagine the flow-through effect on its operating income!

What if your Operating Leverage is Less Than 1?

If a company shows a negative operating leverage it means the company profits are decreasing and it is costing a lot more to deliver the product or service (paying more in variable costs than what it earns in each sale).

High Vs Low Operational Leverage.

Every industry is different and both high/low DOL present different outcomes to investors. A business with a higher fixed cost and low variable cost has a much bigger effect on profits as they go up (or reverse). If a company has a high percentage of fixed costs when demand falls there is more risk associated with operating as it has to keep paying the bills.

Some investors treat high operating leverage as higher risk than lower operating leverage companies. Simply because the low operating leverage business does not have the ongoing burden of larger fixed costs. As it grows so do its costs.

A low ratio means spending is tied to demand/sales. There are however benefits if a business is in a low DOL industry because it can try to become more efficient by implementing cost-cutting strategies to generate higher margins than its competitors.

Forecasting…

Forecasting high operating leverage companies can be very tricky. High leverage can really supercharge profit growth and this is hard to extrapolate out into the future. We need to gauge how much of that profit can flow through to the bottom line. Once a company has established its break-even point an incremental growth in revenue creates higher profit margins.

Small errors in how we forecast can create vastly different valuations in modeling. Once a business passes breakeven sometimes it is hard to determine what future cash flow and profits will be. It is best to think about the business and look at what the potential size of the business can be and what is needed for it to get there.

In Summary…

The preference for high vs low DOL will all come down to your investment philosophy and your investment process. I look for high DOL which naturally leads me toward high-growth or early-stage companies especially ones that have the foundations to scale.

Why? As a company starts to scale (if it can scale) a slight change in revenue has a very large flow-through effect on profits. We just can not appreciate what rapid growth does to a business once it passes its break-even point. When I am looking at a potential investment I try to determine how much of the additional growth will flow down to the bottom line and ultimately Free Cash Flow.

A business that “crosses the chasm” with high Returns on Invested Capital, high operating leverage and growing margins can produce some amazing shareholder returns.