Question

Explain how it affects the variability of the firm’s cash flows, especially as it combines with the firm’s operating leverage in determining the firm’s overall risk profile.

Answer 1

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage

he higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

examining how sensitive a company's operating income is to a change in revenue streams, the degree of operating leverage directly reflects a company's cost structure, and cost structure is a significant variable when determining profitability. (For more, see "What Does a High Degree of Operating Leverage Indicate?") If fixed costs are high, a company will find it difficult to manage short-term revenue fluctuation, because expenses are incurred regardless of sales levels. This increases risk and typically creates a lack of flexibility that hurts the bottom line. Companies with high risk and high degrees of operating leverage find it harder to obtain cheap financing.

In contrast, a company with relatively low degrees of operating leverage has mild changes when sales revenue fluctuates. Companies with high degrees of operating leverage experience more significant changes in profit when revenues change.

Higher fixed costs lead to higher degrees of operating leverage; a higher degree of operating leverage creates added sensitivity to changes in revenue. A more sensitive operating leverage is considered more risky, since it implies that current profit margins are less secure moving into the future.

While this is riskier, it does mean that every sale made after the break-even point will generate a higher contribution to profit. There are fewer variable costs in a cost structure with a high degree of operating leverage, and variable costs always cut into added productivity – though they also reduce losses from lack of sales.

Comment : There is mainly interrelated activities of cash flow and operating leverage which can impact the whole of leverage policy an\d imoact of that on cash flow then it will also cinsider the risk in operating leverage.