Return on equity measures net income, or profit, as a percentage of stockholders’ equity. A higher ROE means a business generates more profit per dollar of equity. Operating leverage measures how much a company’s net income changes based on a change in sales. If your small business has high operating leverage, a small change in sales leads to a greater change in net income, which leads to greater fluctuations in return on equity.
About Operating Leverage
A business with higher operating leverage has higher fixed costs than variable costs. Fixed costs remain unchanged regardless of sales. Variable costs fluctuate with sales. Net income equals sales minus variable costs minus fixed costs. Higher operating leverage is good when sales rise because net income rises faster than it would if you had lower operating leverage. Higher operating leverage has the opposite effect when sales decline because profits fall faster.
Degree of Operating Leverage
Measure your net income’s sensitivity to a change in sales using the degree of operating leverage. DOL equals sales minus variable costs, divided by net income. A higher DOL represents higher operating leverage. For example, assume your business has $100,000 in sales, $30,000 in variable costs and $10,000 in net income. Subtract $30,000 from $100,000, and divide your result by $10,000 to get a DOL of 7.
Effect of Operating Leverage on Net Income
The percentage change in net income based on a percentage change in sales equals DOL times the percentage change in sales, times 100. For example, if your small business has a DOL of 7 and a 5 percent increase in sales, multiply 7 times 0.05 times 100 to get a 35 percent increase in net income. If you instead had a lower DOL of 3 and the same sales increase, your net income would rise by just 15 percent, or 3 times 0.05 times 100.
Return on Equity
ROE equals net income divided by stockholders’ equity, times 100. Stockholders’ equity — which is listed on the balance sheet — is the value of stockholders’ stake in a business. For example, assume your small business has $10,000 in net income and $50,000 in stockholders’ equity. Divide $10,000 by $50,000, and multiply your result by 100 to get a 20 percent ROE. This means you generate net income equal to 20 percent of stockholders’ equity.
Effect of Operating Leverage on ROE
Because net income is the numerator of the ROE formula, operating leverage has a similar effect on ROE as it does on net income. A higher DOL boosts ROE when sales rise, but it also accelerates the decrease in ROE when sales decline. You can increase your DOL by increasing your fixed costs relative to variable costs, but be aware of the negative effects on ROE when sales decrease.
Effect on ROE Example
Using the same numbers and same sales increase from the previous examples, assume your net income increases by 35 percent from $10,000 to $13,500 as a result of the higher DOL. Your ROE would increase from 20 percent to 27 percent, or $13,500 divided by $50,000 and then multiplied by 100. If you had a lower DOL and a 15 percent increase in net income as a result of the same sales increase, your ROE would increase to just 23 percent.
