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Operating Leverage and Margin of Safety

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Operating Leverage

Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase of a company's assets. Business owners can use either debt or equity to finance or buy the company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also increases the company's returns, specifically its return on equity. This is true because, if debt financing is used rather than equity financing equity is not diluted.
Investors in a business like the business to use debt financing but only up to a point. Beyond a certain point, investors get nervous about too much debt financing as it drives up the company's default risk (About.com)

Peavler, R. (n.d.) What is Leverage? About.com (n.d.). Retrieved from
http://bizfinance.about.com/od/pricingyourproduct/qt/what-is-leverage-and-business-financial-risk.htm

Questions for discussion:

Operating leverage and margin of safety are terms used in business, what do they mean? How is capacity and size relating to operating leverage? Can you identify other similar measurements that are useful from a managerial accounting perspective?

You do not need to discuss every question or comment mentioned above. Choose one or two relevant aspects for further investigation and share your knowledge with the class. Try to add information not previously discussed by others. Please, provide information (not merely opinions) backed up by details or examples. Your comments should be in your own words and Include references in APA format, if appropriate.

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Solution Preview

Operating leverage means how revenue growth translates into growth in operating income. This is a measure of leverage and the risk related to a firm's operating income. Specifically it means that the business has a higher proportion of fixed costs and lower proportion of variable costs. For example, before the financial crisis the big three auto makers in the United States had a higher proportion of fixed costs and lower proportion of variable costs when compared with foreign based car makers(1). From a different perspective if a business makes a few sales and each sale provides a very high gross margin, it is said to be highly leveraged. On the other hand, if a business makes many sales with each sale contributing a very slight margin it is said to ...

Solution Summary

The response provides you a structured explanation of operating leverage and margin of safety. It also gives you the relevant references.

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Home Depot: Operating Leverage, Margin of Safety, and Cost

In the early years of the 21st century the housing market in the United States was booming. Housing prices were increasing rapidly, new houses were being constructed at a record pace, and companies doing business in the construction and home improvement industry were enjoying rising profits. In 2006 the real estate market had slowed considerably, and the slump continued through 2007.

Home Depot was one major company in the building supplies industry that was adversely affected by the slowdown in the housing market. On August 14, 2007, it announced that its revenues for the first half of the year were 3 percent lower than revenues were for the first six
months of 2006. Of even greater concern was the fact that its earnings for the first half of 2007 were 21 percent lower than for the same period in the prior year.

Required:
Write a memorandum that explains how a 3 percent decline in sales could cause a 21 percent decline in profits. Your memo should address the following:
a. An identification of the accounting concept involved.
b. A discussion of how various major types of costs incurred by Home Depot were likely affected by the decline in its sales.
c. The effect of the decline in sales on Home Depot's margin of safety.

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