Sunday, November 18, 2012

Understanding Degree of Operating Leverage


The operating, or “fundamental,” risk of a company is the risk a company faces because of the business it is in.  For example, the profits a firm makes depend on the demand for its goods and the costs of producing the goods, so it inherently faces the risk that costs could increase and/or demand could fall, which would affect the profits of the firm.
Operating risks result from the investment decision of the firm, and are separate from financial risk, which results from the financing decision.   One way to measure operating risk is through activity analysis, which studies how the operating activities of the company generate profits, see below.
Fundamental Risk and Beta
 A different measure of risk, beta, is based on stock returns.  It measures the sensitivity of a stock’s return to the market as a whole.  In its pure form, it does not pay attention to fundamentals.  However, people have developed the concept of a “fundamental beta” which takes into account information such as operating and financial risk.  One argument in favor of this approach is that beta typically is calculated using historical data, while fundamentals provide information about the future performance of a firm. 
So one question you can ask is whether beta reflects fundamental risk.  For example, do firms with high operating risk have high betas, or more broadly, if there is a systematic relationship between beta and fundamentals.
Operating Risk
 Operating risk in “Activity Analysis” is measured by the “Degree of Operating Leverage.”  The ideas underlying this measure can be developed as follows.  From the firm’s financial statements we can first estimate a firm’s Earnings Before Interest and Taxes (EBIT) which provides a measure of the operating income for a firm.  One measure of operating risk is the Degree of Operating Leverage (DOL) defined by
Degree of Operating Leverage (DOL) = % Change EBIT/% Change in sales revenue
This definition is related to the concept of elasticity in economics: it measures the percentage change of one variable due to a percentage change in another.  So here, operating risk is defined as the elasticity of a firm’s EBIT to Sales Revenue. 
Why is this measure of operating risk?  Because it tells you how sensitive profits are to changes in sales.  If they are very sensitive, then it could mean, for example, that the firm has high fixed costs, so it is more exposed to a downturn in sales than a firm with low fixed costs.  Numerically, consider a firm that has a fixed cost of $50m and then a variable cost of $1 per unit.  If it sells 100m units at $2 each, it has a profit of $50m (200m in revenue minus 100m in variable costs minus 50m in fixed costs).  If sales drop by 10% to 90m units, profit drops to 180m – 90m – 50m = 40m, which is a 20% drop in profit.  If the same firm had zero fixed costs, its profit would drop by 10% if sales dropped by 10%.
In the lesson, you will learn how to calculate the DOL for Wal-Mart and Intel.  Then, you will compare them to the betas, and see if a higher DOL is associated with a higher beta.  At the end of the lesson is an exercise that lets you conduct a more systematic analysis of the relationship between operating risk and beta.
To access the lesson, from the FSA module, simply select it from the Lessons menu:


Wednesday, October 17, 2012

Self Study Guide Now Available

Click here to view. 

Tuesday, October 9, 2012

Understanding FSA Concepts and Calculations


In this blog, I illustrate how our “Concept Check” feature lets you reinforce your understanding of the concepts specific to the topic you are studying. 

By reading other parts of this site or watching the videos, you have seen how to take information from the statements and construct ratios.  This is the “practice” part.  But you may not be as familiar with some of the calculated values (blue background) or exactly how they are calculated.   This is where the “Concept Check” comes in.  For the illustration, I will use the part of profitability analysis that calculates ROA and ROE.
Start by clicking the “Concept Check” icon:


Once you do, you will see:


There are three calculated concepts in this topic:
Net Income Attributable to Shareholders
Return on Assets
Return on Equity

You can learn how each concept is calculated by simply dragging and dropping the terms themselves into the blank area on the right, add arithmetic operators, and create a formula.  If you click on the Explanation tab, you will see the definition of each term.
Let’s do an easy one: Net Income Attributable to Shareholders

This is simply Net Income minus Net Income Attributable to NCI.  So simply drag and drop the two terms and type in a minus sign in between:



By repeating this, you will become very familiar with both the explanation and the formula underlying a concept. 
If you just want to explore concepts, in any order and without worrying about where they are used, select the branch “Learn Calculated Concepts”


If you click on a concept, it will give you a definition, but will also tell you where it is used.  In the picture, the Accrual Ratio (Balance Sheet) is used in a sub-branch of “Analyze Earnings Quality” and you can see its definition.
If you select “Learn Calculation,” you will see:


You can again drag and drop the terms to create a formula and see if you know how the specific concept is calculated: