In this article, we will learn how to analyze corporate leverage using Python. First, we'll start with a brief introduction to what leverage is and how to explain it. Then, we'll turn to Python to learn how to calculate the degree of financial leverage. Coding is very easy, as we'll see.
Measuring Company Leverage
All companies face two levels of risk that affect stock prices. On the one hand, companies face commercial risks, including sales risks and operational risks. On the other hand, they may also face financial risks related to the company's capital structure and the amount of financial debt.
There is a clear distinction between business risk and financial risk. Business risks include factors such as the structure of the industry, the economic cycle we operate in, and the company's cost structure (variable versus fixed). Financial risk has more to do with a company's capital structure and the amount of debt.
Now we know more about these two risk levels. We can relate them to the company's total leverage ratio. On the one hand, our operating leverage measures the use of fixed versus variable costs in a company's cost structure, so it is related to business risk.
On the other hand, we have financial risks that can be linked to the company's financial leverage.
Therefore, the company's total leverage ratio can be calculated as follows:
Total leverage ratio = operating leverage ratio * financial leverage ratio
High leverage increases the volatility of a company's earnings and, therefore, its cost of capital.
operating leverage
Operating leverage depends on the industry the company is in. For example, airlines tend to have higher fixed costs. The reason is that they have to invest a lot of money in the aircraft. In order for airlines to make money, they need to operate their fleets of planes at almost 100% capacity because the variable costs (that is, the cost per passenger) are very low.
Operating leverage is not a factor that company management can easily influence as it is inherent in the industry. For example, it is impossible for management to control the economic cycle we are in. Or for airlines, reducing the level of fixed costs when aircraft operations are required.
Operating leverage (DOL) can be calculated as follows. We first need to know the company's contribution margin rate in order to calculate the company's DOL. for