Operating Leverage
The Often Overlooked Risk Factor
Dr. Israel Shaked1
David Plastino, CPA/ABV
Many corporate insolvency and restructuring professionals spend a large portion of their
professional lives analyzing and quantifying risk, both in reorganization proceedings and
litigation. For example, attorneys, financial advisors and judges are frequently called upon to
decide the appropriate level of debt for a reorganized debtor, while a fraudulent conveyance
action may focus on whether or not actions taken by a corporate board, creditor, or acquirer left a
company in an unsustainable financial position.
Risk and capital adequacy assessments performed in these situations often focus on a
company’s financial leverage – defined generally as a company’s debt burden relative to the cash
flow generating potential of the firm’s assets. However, this is only one element in determining
whether a firm is adequately capitalized and able to support its debts. Another is the potential
volatility of a company’s earnings and cash flows. By volatility we mean the probability that the
company’s actual results will diverge substantially from its projected results, as well as the size
of that potential divergence. All other things being equal, a company that exhibits sudden and
sharp changes in its sales and cash flows can generally support less debt than a company that has
been historically stable and is projected to remain so in the future.
Most practitioners see volatility as a function of varying factors including, but not limited
to the nature of the industry, its sensitivity to economic fluctuations, and the products produced
1
Israel Shaked is the Managing Director of The Michel-Shaked Group and professor of finance and economics at
Boston University’s School of Management. He is a Coordinating Editor of the ABI Journal. David Plastino is a
Senior Vice President at The Michel-Shaked Group and a Lecturer in Finance at Boston University’s School of
Management.
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by the firm. Thus, advisors and attorneys are typically aware that what constitutes “too much
debt” is relative to the business and industry in question. Cyclical industries, which show regular
variations tied to the economic cycle, often have less financial leverage than non-cyclical
industries. Other, more stable, industries and companies can often support higher indebtedness
without adverse consequences. Thus, it is common for practitioners to look to comparable
companies and industry statistics for guidance in determining how much debt is appropriate for a
reorganization plan, or the upper limit of reasonable financing in a leveraged buyout or
recapitalization.
While helpful, an analysis of industry volatility and peer company debt levels fails to
fully account for the risk of a specific company. To understand why, it is first necessary to
understand the nature of leverage. Leverage is any tool which magnifies the returns (both
positive and negative) of a company. The most commonly understood form of leverage is
financial leverage (debt), which companies use to magnify returns to equity holders. However,
leverage consists of more than financial engineering. Every firm’s Total Leverage (TL) is made
up of two components: Financial Leverage (FL) and Operating Leverage (OL). These two
elements in combination determine the volatility of a firm’s cash flows to equity holders. In
short:
TL = FL + OL
Financial leverage, as discussed above, generally refers to debt financing, or the way in
which a firm apportions its cash flows and earnings between its debt and equity investors. Debt,
which bears a fixed obligation to pay interest and principal and is superior to equity in a
company’s capital structure, generally has a lower cost than equity. Thus, a company which
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substitutes additional debt for equity by borrowing money to repurchase shares effectively
increases its fixed financing costs. In good times, the cost of debt is fixed, and thus incremental
cash flows go primarily to equity holders. This increases the value of the firm’s equity at a rate
greater than the rate of increase in the value of the firm as a whole. In bad times, the interest and
principal on the debt must still be paid, meaning that equity holders share disproportionately in
the loss of firm value. A company with high debt relative to its equity is said to have high
financial leverage. Attorneys, financial advisors, and the courts tend to focus on financial
leverage whenever a company’s viability, or ability to continue as a going concern into the
foreseeable future, is being debated. Operating leverage, which can be just as important as
financial leverage, is often overlooked.
Operating leverage is conceptually similar to financial leverage, except that it refers to
the division of a company’s operating costs between fixed and variable elements. A company
with high operating leverage has high fixed costs of operation relative to its total cost base. To
understand the difference between fixed and variable operating costs, consider a manufacturer
who makes rubber balls. To this manufacturer, rubber is a variable cost. As the number of
rubber balls sold increases or decreases, the total amount the firm spends on rubber will vary.
The cost of the company’s mortgage on its manufacturing facility, on the other hand, is a fixed
cost. Regardless of the number of balls the company sells, that payment will remain the same.
When sales increase, firms with higher operating leverage will enjoy faster profit and
cash flow growth than less leveraged firms. Conversely, during market downturns, a firm with
high operating leverage will see its margins and cash flows deteriorate more quickly. Thus, like
financial leverage, operating leverage is a source of cash flow volatility and risk.
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It is important to note that two companies with similar products, similar markets, and
similar debt levels can still have substantially different degrees of operating leverage. Consider,
for example, a company that owns its production facilities and production equipment versus its
competitor that outsources all its production to a contract manufacturing facility. All other
things being equal, when sales are rising, the second company will have lower profit margins
than the first. This is because its contract manufacturer, which also has to make a living, “eats”
part of the profits. During bad times, when sales decline, the second company will have better
margins as it can simply purchase fewer units, while the first company still has to pay expenses
related to its manufacturing facility and equipment. The second company is, in effect, giving
away upside returns in good markets to partially protect it from market downswings. Thus, its
volatility is lower than that of the first company. Volatility is a key component when analyzing a
company’s viability and ability to continue as a going concern into the foreseeable future.
To determine exactly how much the Earnings Before Interest and Taxes (EBIT) of each
company in the above example will vary with changes in sales requires a relatively simple
analysis. First, the company’s Cost of Goods Sold and Selling, General & Administrative
expenses should be separated into variable costs and fixed costs. As shown in Figure 1, both
Company A and Company B have the same sales and EBIT, but Company B has higher variable
costs, while Company A has higher fixed costs. Sales minus variable costs is known as
Contribution Margin. Contribution Margin represents the amount available to cover all other
expenses and distributions after variable costs of producing a product have been paid, and can be
expressed as either a dollar value or a percentage. In our example, the Contribution Margin for
Company A is $700,000, or 70%, and the Contribution Margin for Company B is $550,000, or
55%.
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FIGURE 1:
Company A
$1,000,000
300,000
700,000
200,000
500,000
Sales
- Variable Costs
= Contribution Margin
- Fixed Costs
= EBIT
Company B
$1,000,000
450,000
550,000
50,000
500,000
We can then utilize the following formula to compute each company’s Degree of
Operating Leverage:
Degree of Operating Leverage (DOL) = Contribution Margin (CM)
CM – Fixed Costs (FC)
The computation of the Degree of Operating Leverage for each company is shown in
Figure 2. The equation derives a DOL of 1.4 for Company A and 1.1 for Company B. The DOL
tells a user by how much EBIT will change for every $1 change in sales.
FIGURE 2:
Company A
DOL
=
CM
CM - FC
700,000
=
700,000 -200,000
Company B
1.40
550,000
550,000-50,000
= 1.10
Now consider the following example, illustrating a downside case scenario in which sales
at both Company A and Company B decline from $1,000,000 to $750,000, a 25% drop.
Assuming that this decline is due to a decrease in volume, not selling price, each company’s
variable costs and Contribution Margin will remain the same percentage of sales. Fixed costs at
both companies will remain the same, thus becoming a larger percentage of sales. EBIT will
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decline to $325,000 and 362,500, respectively (see Figure 3). Therefore, Company A’s EBIT
has declined by $175,000, or 35%, and Company B’s EBIT has decline by $137,500, or 27.5%.
FIGURE 3:
Sales
- Variable Costs
= Contribution Margin
- Fixed Costs
= EBIT
Company A
$750,000
225,000
525,000
200,000
325,000
Company B
$750,000
337,500
412,500
50,000
362,500
These detailed computations produce the same result as multiplying the decline in sales
(25%) by the DOL factors computed above.
Percentage Change in EBIT = Change in Sales * DOL
Company A Percentage Change in EBIT = -25% * 1.4 = -35%
Company B Percentage Change in EBIT = -25% * 1.1 = -27.5%
While we discuss traditional manufacturing companies in the example above, it is
important to note that almost all firms, regardless of the industry they are in, have both fixed and
variable costs. Whenever both fixed and variable costs exist in a company’s operational
structure, this framework can be utilized.
Use of DOL factors proposed above can provide a number of advantages to a bankruptcy
professional. First, they give an easy and intuitive way to stress test “base case” financial
projections that are often prepared in connection with deals and reorganization plans. Such
projections often apply fixed margins to sales to derive EBIT and cash flows. However, as
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shown above, margins do change. In fact, the higher the percentage of fixed costs in the
company’s cost structure, the more variance there will be in margins under both upside and
downside scenarios.
Realizing this, many advisors reduce a company’s margins when performing stress tests.
Often, these margin reductions are subjective estimates, or are based on the company’s historical
margin fluctuations. Such analyses require significant judgment and can therefore produce
misleading results. Companies often appear in bankruptcy court because they have undergone
significant changes. A reorganized company, for example, may have been able to significantly
reduce its fixed costs through the bankruptcy process by rejecting contracts and leases. Relying
on historical margin fluctuations would, in such cases, overestimate the operating risk of the
company. In leveraged buyouts (including failed LBOs) the acquiring company often intends to
change the acquired firm’s operations significantly through both cutting costs, outsourcing
production, or expanding operations. These changes could lead to higher or lower fixed costs
and, therefore, to higher or lower margin volatility than would be indicated by the company’s
historical results. DOL factors can take these changes into account, as long as they are computed
using the mixture of fixed and variable costs that will apply over the projection period being
assessed.
In summary, it is our opinion that many cases of bankruptcy and financial distress could
benefit from a more careful examination of operating leverage. Despite its importance to the
volatility of a firm’s cash flows, operating leverage is often overlooked, or improperly analyzed.
Utilizing the equation presented in this article to compute a company’s Degree of Operating
Leverage is a one-time investment that can allow a bankruptcy practitioner to quickly assess the
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operational risk of a company. With a DOL factor in hand, it is then easy for a practitioner to
calculate EBIT under any given sales forecast without stepping through a full financial analysis.
That, in turn, can enable better decisions, and help ensure that the subject company’s liabilities
are structured in such a way as to ensure that it remains a viable, going-concern entity.
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