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Financial and Operating Leverage in Uncertain Economies

June 06, 2012 | Comments: 0 | Views: 242

Operating Leverage and Financial Leverage can be paramount for a company to survive an economic downturn. High Financial and Operating Leverage are undesirable for a firm at any point, but are much worse in a time when revenues are declining. Financial Leverage increases when firms take on more debt, increasing their Liabilities. Higher Financial leverage increases a firm's risk because the firm has to pay back that debt, even if revenues have slowed or even stopped. Operating Leverage increases when a firm has larger amounts of Fixed Costs. Similarly to Financial Leverage, higher Operating Leverage increases the Breakeven Point for that company, which is troublesome especially in a slow economy.

In 2009, Chrysler, Ford and GM had high Financial and Operating Leverages and in that year, 2 were forced to file for chapter 11 bankruptcy. A brief snapshot of Ford and GM's financials show their high Financial Leverage:

Ford:

2009

Assets

$203,000,000,000

Debt Ratio:

103.45%

Liabilities

$210,000,000,000

Equity

$ (6,520,000,000)

GM:

2009

Assets

$ 136,860,000,000

Debt Ratio:

78.84%

Liabilities

$ 107,900,000,000

Equity

$ 28,960,000,000

Ford had a Debt Ratio of over 103 percent the year the company filed for bankruptcy; GM had a Debt Ratio of over 78%. All three of these corporations had high operating leverage resulting from large fixed costs, partly from compensation of employees, including pensions and retirement plans. As the economy slowed from 2007 to 2009, The Big Three were in serious trouble as revenue streams dried drastically increasing their vulnerability. The companies began two realize that they would not have enough Working Capital to keep afloat and all three had to receive outside funding (Chrysler and GM from the bailout and Ford from a line of credit).

More than three years removed from the bailout of Chrysler and GM, have the Big Three learned from their mistakes? So far, it appears that both Ford and GM have lowered their risk and Financial Leverage.

Ford:

2011

Assets

$ 178,350,000,000

Debt Ratio:

91.55%

Liabilities

$ 163,280,000,000

Equity

$ 15,070,000,000

GM:

2011

Assets

$ 144,600,000,000

Debt Ratio:

73.04%

Liabilities

$ 105,610,000,000

Equity

$ 38,990,000,000

Both Ford and GM improved their Debt Ratio. Ford lowered their ratio close to twelve percent while GM lowered theirs more than 5 percent. This has decreased their financial vulnerability if another global anomaly happens to decrease demand within their industry and revenues suffer because of this.

Both Ford and GM have also made strides to decrease their Fixed Costs, which will make their Operating Leverage more desirable. Cost of Goods Sold for both companies has decreased since 2009. Ford's ratio of Cost of Goods Sold to Revenue (COGS/Revenue) decreased from 85.72 % in 2009 to 79.20% in 2011. The same ratio for GM decreased from 107.45% in 2009 to 87.78% in 2011. Since it is unlikely that there has been any significant advances in machinery or technology that drastically reduce production cost on a per unit basis, it seems that both corporations have found a way to lower their fixed costs, bettering their Operating Leverage. It is unknown if Chrysler has fared better or worse, post-bailout, as it is a private corporation and their financials are not made public.

With economic uncertainty a challenge facing all businesses, it seems that Ford and GM have learned from mistakes they have made in the past. They have been able to reduce the risk in which they operate as well as change their operational model in order to better satisfy demand. Both Ford and GM have changed the types of cars that they produce, moving to more economical and fuel-efficient models that are in demand, increasing revenues in both companies. It should also be noted that the increase in units sold and revenue can be, at least partially, attributed to the fact that many consumers are less afraid of buying Chrysler, Ford and GM models because there is a smaller chance that their car will be orphaned; meaning that their car's manufacturer will go out of business and the customer will not be able to get service or parts for their car.

No one can predict future. Revenue for The Big Three could skyrocket, plummet or fall somewhere in between the two in the next few years. Regardless of what happens, they have taken significant steps to assure that they will be protected from the mistakes that they have made in the past by decreasing their risk when they made efforts to lower their Liabilities and Fixed Costs to improve their Operating and Financial Leverage, as well as creating products that better satisfy the needs of potential customers. Hopefully, these business strategies will keep these American companies in business and American workers out of the welfare office.

Source: EzineArticles
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