CFA Level I · CFA Level I Exam · Financial Statement Forecasting in Equity Valuation
An analyst forecasts that a company with a high degree of operating leverage will see sales fall 10% next year. Compared with a similar company with low operating leverage, the high-leverage company's operating income decline is most likely:
The high-leverage company's operating income will fall by a larger percentage because its fixed costs do not decline when sales fall. Its cost structure is less flexible, so the sales decline is magnified in operating income, more than for a firm with mostly variable costs.
- Asmaller in percentage terms, because its variable costs are lower
- Blarger in percentage terms, because fixed costs do not fall with salesCorrect
- Cthe same in percentage terms, because both face an identical sales decline
Explanation
High operating leverage means a larger share of fixed costs. When sales fall, fixed costs stay the same, so operating income falls by a larger percentage than sales. The low-leverage firm's costs adjust more with sales, giving a smaller percentage decline.
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