Terms Beginning With 'o'

Operating Leverage

  • January 07, 2020
  • Team Kalkine

What is operating leverage?

Operating leverage is a measure to evaluate the transition of top-line movement into bottom-line change. It essentially measures the change in operating profits as a function of change in sales. Operating profit is alternatively referred to as Earnings Before Interest & Taxes (EBIT)

High operating leverage means when a slight increase/decrease in sales for business results in even higher/lower increase in operating profits. Similarly, operating leverage is low when an increase in sales results in almost no or a slight increase in operating profits. 

It specifies the degree to which firms incur the mix of fixed and variable costs. Fixed costs are incurred one time and remain same irrespective of change in volume, while variable costs change alongside a change in volumes. 

In an effort to improving operating leverage, the company would intend to substitute its variable costs with fixed costs, thus the growth rate of earnings will be relatively higher compared to the growth rate of revenue. 

But the company will be required to break-even to see operating leverage. Since variable costs are decreased, the contribution to the profits from each unit would be more than earlier. 

With high operating leverage, the production volumes should increase to cover the fixed costs, and firms with low output levels may not benefit from the operating leverage. Capital intensive businesses like manufacturing firms have higher fixed costs, and operating leverage becomes appropriate to evaluate such firms. 

How to calculate operating leverage?

Since the information in financial statements is limited, there are several formulas to calculate operating leverage. Financial statements of a business would not necessarily provide the elements of cost. 

It depends on the information in hand to use the formula. The audited financial statements of a company may not provide you with items likes fixed costs, variable cost or contribution margin. Therefore, formula 3 is an appropriate measure to calculate operating leverage, especially when the information is limited. 

How to interpret operating leverage?

It is important that comparison of operating leverage should be an apple to apple comparison and certainly not apple to oranges. Moreover, similar businesses should be compared on the basis of operating leverage for an effective assessment. 

Consider firm A has revenue of $2 billion, operating income of $400 million, and operating leverage of 2x. Firm B also has the same revenue and operating income, but operating leverage is 1x. 

With operating leverage of 2x, a 10% increase in revenue for firm A to $2.2 billion would result in operating income of $480 million. In contrast, firm B has operating leverage of 1x, which means a 10% increase in revenue to $2.2 billion translates to operating income of $440 million. 

When sales are increasing for firm A, it means that operating income will increase for the firm more than the rate of growth in sales. However, when sales are falling for firm A, the operating income will fall at a rate more than the rate of fall in sales. 

What impacts operating profits or margins?

Although operating leverage defines the operating profits for a firm, there are many other factors that also impact the operating profits for the firms. These factors can be broadly classified into two categories: sales and economics. 

Sales of a firm 

Until now, we have argued that sales impact the operating profit of a firm, and the degree of the impact on operating profit is defined by operating leverage. Now we discuss how sales are impacted for a firm.

Economic Growth: Sales forecast for a firm is also based on the economic forecast of the region. When overall economic growth is expected to decline, it is highly likely that sales for the firm would also decline as a result. But this is not true for all businesses since non-cyclical businesses like consumer staples, the utility could remain unscathed from the decline in economic growth. Meanwhile, economic growth also sets the trajectory for the growth of the company.  

Industry Growth: Sales of a company are likely to move consistently with growth in the industry. However, a firm could grow even while industry growth is declining, largely because of short-term factors like new business/product, acquisition, price competition. Forecasting industry growth remains crucial to forecast company sales, while the industry cycle is also important to consider. 

Market Share: A firm can drive its sales when market share is increasing, and incumbent competitors are losing market share regardless of economic growth and industry growth. Firms are able to improve market share through product innovation, marketing, price wars etc. 

Inorganic Growth: Companies could also increase sales through mergers and acquisition, while also getting rid of competition concurrently. The intent behind inorganic growth options is to improve market share, customer base and economies of scale. 

Economics of a firm 

The impact of sales on profits is determined by the economics of the firm. Operating leverage is also a part of the economics of a firm along with other factor defined below. 

Volumes: Earlier, we noted that a firm is required to increase the volume of production to lower the variable cost per unit. The growth in sales should also be backed by the increase in production to gain operating leverage. 

Price mix: When firms have pricing power, they can increase the price of the products without losing much of the demand. Increase in price with a relatively smaller increase in quantity would add to the profit margins for the firm. 

Economies of Scale: Companies exercise economies of scale when enhancement to processes and scale leads to lower per-unit cost of production. For example, when a large firm acquires a small firm, the marketing and sales could be integrated with a large firm, therefore saving costs incurred by the target company. Margin expansion through economies of scale is a result of the allocation of costs across larger volumes. 

Cost efficiencies: Cost efficiencies could be achieved by the company irrespective of sales growth and contribute to the operating profit margin for a firm. This could be undertaken through innovation, research and development, therefore replacing old processes with new ones at lower costs.

What is Data Analytics?  Data Analytics involves a set of quantitative and qualitative approaches and processes that can be used to determine useful information for business decision-making. The process involves various patterns and techniques, including: extracting a raw database, and categorising it to identify and analyse the behaviour, relation and connection of the results.  The ultimate goal is to acquire valuable information in order to make decisions for businesses’ benefit and productivity.  In today's competitive times, most companies chalk out their business plan with the help of data analytics. With organisations becoming customer-service oriented, data analytics has become a critical tool to reach the target audience in an effective manner while understanding their requirements. Once data is collected, it is analysed and stored according to organisations’ requirements.  The data analysis process has multiple layers involved, and its diverse modules are not just used in businesses but also in science and social science fields. Rather than making decisions based on just available information, one can utilise data analytics in examining the data in standard ways and churning out the results from it.  It has been observed that companies generally make decisions based on past references and future outcomes. Data analytics appears advantageous in providing useful information towards this end.  Why do Businesses Need to Use Data Analytics?  Many data analytics’ tools and softwares are readily available these days. These systems use resources, such as machine learning algorithms and automation.   Data scientists and analysts are counted amongst the leading career options as well. These professionals use data analytics techniques while researching and presenting useful information for businesses to increase productivity and gain. The process helps companies understand their target audience and determine effective ways to cater to their needs. Data analytics can further be used to design strategies in marketing campaigns and promotions and also evaluate its results.  Data analytics is primarily used in business-to-consumer (B2C) processes to boost business performance and improve the bottom line. There are data collection firms which gather consumer information and provide it to the businesses so that the companies can effectively influence the market. The collected data is not only used to understand and impact consumer behaviour but also determine market economics and its practical implementation.  The data used in the process can be either be data collected in the past or newly updated data. There are various methods to manage consumer and market information. It may come directly from the customers or potential customers or can be purchased from the data collection vendors. The data primarily includes audience demographics, behavioural patterns and expense threshold.  How Can Data Analytics be Effectively Used in Business Processes? Data analytics is an ever-evolving technique. Earlier, the data was collected manually, but with the rise of internet and technology, data is now collected online with the help of search engines and social media platforms. Subsequently, the information is analysed through available software.  Here is a list of some key steps businesses can follow to leverage the benefits of data analytics: Set up crucial metrics: This step reduces the guesswork and provide data-based insights to the businesses. Before embarking on the data analytics process, it is vital to determine the goal for your business. Analysing customer data helps in understanding conversion rate, consumer spending ability, demographics etc. The results of the analysis can support the businesses while making decisions in launching an advertising or marketing campaign. Similarly, the unwanted data can be erased from the database so that the brands can focus on their right target audience. The relevant metrics will change the course of the company and push it in the right direction. Moreover, once your key metrics are set, even when the market conditions change in the future, you can adjust the metrics according to the requirement and achieve the results. Set a clear module: It is important to examine the data correctly by avoiding common mistakes. An ambiguous path can produce confusing insights while wasting time and energy of businesses.  Therefore, it is recommended to draw a clear goal in order to achieve actionable insights. The data, when collected from different sources, need to be merged accurately in the analytics model. Businesses can modulate their data analytics systems either manually or through automation. There are various data modelling practices available in the market. The best use of these techniques can simplify the process of modelling complex data.  Data visualisation: Once the relevant data is collected, and the modules are set to analysis, visualisation of that data will assist in understanding the information correctly. When the businesses have an acute knowledge of what their target audience wants, they can then focus on strategising advertisement and content, which matches the consumers' interest.  It is the critical step in the data analytics process to distinguish insights from information.  Not everyone is comfortable dealing with numbers. Hence, ensuring that key stakeholders understand essential points and information can be displayed in a visually appealing format seem crucial to capitalise on data effectively. Right tools to implement insights:Having access to data and insights can get overwhelming. However, the information is worthless if the businesses are unable to implement it successfully. While it is important to collect the data and set critical metrics and modules to analyse it, it is also imperative to translate the data into practical actions. The eventual goal is to improve sales or grow profits. It is ultimately in the marketers' hands to transform the gained insights into a successful implementation. The consumers' insights should be incorporated while establishing a marketing plan and at all decision-making steps. 

What is Day Trading? Day trading is popular among a section of market participants. It is a type of speculation wherein trades are squared-off before the market close in the same day. An individual or a group is engaged in buying and selling of securities for a short period for profits, the trades could be active for seconds, minutes or hours.  One can engage in day trading of many securities in the market. Anyone who has sufficient capital to fund the purchase can engage in day trading. For a class of people, day trading is a full-time job.  Day traders are agnostic to the long-term implications of the security and motive is to benefit from the price changes on either side and make profit out of the asset price fluctuations within a day. They bet on price movements of the security and are not averse to take short positions to benefit from the fall in price.  Day trading is not only popular among individuals or retail traders but institutional traders as well, therefore the price movements are large sometimes depending on the magnitude of information flow and accessibility.  Everyone wants to make money faster, and many are inclined to speculate in markets, but it comes with considerable risk and potential loss of capital. People engaged in day trading also incur losses, and oftentimes outcomes are disheartening.  Day trading is a risky activity, similar to sports betting and gambling, and it could become addictive just like gambling and sports betting. Since the motive is to earn profits, the profits realised from day trading also tempt people to continue speculating.  People spend considerable time and efforts to make the most out of day trading. They have to continuously absorb and incorporate information flow, which has become increasingly accessible driven by new-age communications systems like Twitter, Facebook, forums etc. But not only information flows have been favourable, day traders are now equipped with best in class infrastructure to execute trades even on compact devices like mobile phones. The accessibility to markets is at a paramount level and gone are days of phone call trading and lack of information flows.  What are the essentials for Day Trading? Basic knowledge of markets With lack of basic knowledge of markets, day trading may yield unacceptable outcomes. It becomes imperative for people to know what’s on the stake. Prospective day traders should know about capital markets, and the securities traded in capital markets like bonds, equity and derivatives.  Buying shares and expecting a return from the price movements are on the to-do list for many. However, it is important to know about and risks and potential returns from speculating in capital markets.  After getting some basic knowledge about markets and securities, aspiring day traders should know how to analyse market prices of securities through fundamental analysis and technical analysis. Although day traders don’t practice fundamental analysis extensively, they spend considerable time to apply technical analysis, to formulate a entry and exit strategy.   Device and internet connection Trading is now possible on mobile applications as well as computer applications or websites. An aspiring day trader will likely begin with mobile phone given the accessibility, and laptops/computers are useful as scale grows larger and complex.  Internet connection is prerequisite to practising day trading, and it is favourable to have a fast internet connection to avoid glitches and potential problems. These perquisites are now available with large sections of societies.  Broker and trading platform A broker will facilitate a market for potential trades. The security brokerage industry has also seen a profound shift as technology has driven cost lower while competition is ramping up across jurisdictions. Large retail brokerages have moved towards zero commission trading in the U.S., and the same is seen being the trend across other geographies as well.  The entry of discount and online brokerages has perhaps given wings to the retail market participants as well as the retail market for security brokers. Robinhood has grown immensely popular in the United States, but there are many firms like Robinhood in other jurisdictions. Each country has some firms with business model on same lines as Robinhood.  Brokers now offer high-quality mobile applications and web services to clients, and trading security has never been so accessible. They also provide access to the global market along with a range of securities, including commodity derivatives, currency derivatives, CFDs, options, futures, bond futures etc.  Real-time market information flow   On public sources, market price information is at times not live due technical shortcomings, which will not work appropriately, especially for day traders. Brokers not only provide platform and market but several other services, including margin lending, real-time data, research.  Day traders closely track prices of securities and overall information flow to incorporate developments in bidding, and real-time data provides accurate prices throughout market hours.  Information flow largely relates to the news around the company, industry or economy. Day traders now have far better sources of information than the conventional sources, and sometimes these sources could be exclusive to a group.  What are the risks of day trading? Most of the aspiring day traders end up losing money, given the lack of experience and knowledge. They should rather only bet on capital that they are comfortable to loose, in short, they should avoid risk of ruin. Day trading is sort of pure-play speculation and application of knowledge, information flow, laced with good trading system is paramount. The only concern of day traders is movement in price, which contradicts from investments. Day traders try to time and ride the momentum in the price and exit the trade before momentum turns otherwise, which can happen frequently.  It consumes considerable time and induces stress on the individuals given the nature of security prices, which can move north and south abruptly throughout the day, hours, minutes and seconds. Day traders should have enough capital to trade in cash instead of margin.  Day trading on margin or borrowed money is extremely risky and has the potential to make a person insolvent, especially in cases of extreme risk-taking. The leverage associated with borrowed money magnifies profits as well as losses.  Aspiring day traders should equip themselves with adequate knowledge, competency and sound risk management process. Although fast money is dear to most, it is better to know what is at stake before jumping into markets with excitement.   

An earnings announcement is a public statement of a company’s earnings, usually done on a periodic basis. These official announcements are released quarterly or yearly to inform the investors and the market about a company’s financial performance. Companies announce their financial reports through press releases on their websites and list them on the stock exchanges website. After the information is released through a conference call, there is a question-and-answer round with the senior management in which analysts, media, and investors can participate. On the basis of the report, analysts then incorporate earning measures such as EPS (Earning Per Share). These reports help investors in making sound investment decisions. Earnings results are announced during the earnings season on a date chosen by the company. Stock prices of the companies take a swing before and after the company releases its earnings report. Equity analysts also predict earnings estimates through their analysis which drives stock prices movement due to speculations. Stock prices even move after the earning results are declared, up or down, depending on how the results have turned out. Source: Copyright © 2021 Kalkine Media Pty Ltd. When are earning announcements made? It is mandatory for every listed company to report its quarterly financial results in the US but not in Australia. In Australia, companies release their financial report on a semi-annual basis. Having said that, many Australian companies also update their shareholders quarterly, but these are not considered official earnings. These quarterly reports are released to satisfy the market demand for information and to disclose the company’s guidance on its performance. The financial calendar varies from country to country and therefore, the earnings season changes as well. In the US, the earnings season starts after the final month of the financial quarter. Usually, American companies start posting their earnings reports in January, April, July, and October. In Australia, companies report twice a year, usually around February and August, or May and October. It depends upon the company’s financial cycle. However, whether quarterly in the US or semi-annually in Australia, these earnings results are required as agreed while listing the company with the stock exchanges. Source: Copyright © 2021 Kalkine Media Pty Ltd. Why are earnings announcements necessary? Financial results help investors, media, and other stakeholders of the company to have a greater understanding of the company’s financial footing. Companies not just provide sales, operating profit, net profits, but also offer guidance and outlook for coming months. Additionally, these reports also have senior management statements directed at the market. Therefore, earning announcements act as an informative document for the investors and analysts to study and gauge a company’s performance. Analysts can provide earnings estimates, and investors can then take wise investment decisions. These documents are also vital for companies when it comes to seeking funding for the business. Financial institutions can also judge a company’s financial health by evaluating earnings reports. The management offers insights on growth drivers, risk factors, etc that impacted the earnings during that particular period. Analysts also assess the earnings results, taking into account the external factors that drove the growth or impacted the firm negatively. These factors could be mergers and acquisitions, bankruptcies, economic discrepancies, policy changes, etc. For investors, earnings reports are essential because these announcements swing the price up or down. Traders keep a keen eye on these reports as it can be a time when they can confirm positions. However, some investors also avoid earnings seasons because of the involvement of various human factors.

Earnings Before Interest Taxes and Amortisation (or EBITA) is an operating performance measure of a company, which assist investors in comparing companies stripped of their capital allocation decisions, post considering the depreciation into account.

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