Operating leverage and financial leverage can be critical to a business surviving an economic downturn. High financial and operating leverage is not desirable for a company at any time, but it is much worse at a time when revenues are declining. Financial leverage increases when companies go into debt, increasing their liabilities. Higher financial leverage increases a business’s risk because the business has to pay off that debt, even if revenue has slowed or even stopped. Operating leverage increases when a company has higher amounts of fixed costs. Similar to financial leverage, higher operating leverage raises the breakeven point for that company, which is problematic, especially in a slow economy.
In 2009, Chrysler, Ford, and GM had high levels of financial and operating leverage, and in that year, 2 were forced to file for Chapter 11 bankruptcy. A brief snapshot of Ford and GM’s finances shows their high financial leverage:
Ford:
2009
Assets
$ 203,000,000,000
Debt ratio:
103.45%
passive
$ 210,000,000,000
Capital
$ (6,520,000,000)
GM:
2009
Assets
$ 136,860,000,000
Debt ratio:
78.84%
passive
$ 107,900,000,000
Capital
$ 28,960,000,000
Ford had a debt ratio of more than 103 percent the year the company filed for bankruptcy; GM had a debt ratio of more than 78%. All three corporations had high operating leverage as a result of large fixed costs, partly from employee compensation, including pensions and retirement plans. As the economy slowed from 2007 to 2009, the Big Three found themselves in serious trouble as income streams dried up and their vulnerability increased dramatically. The two companies began to realize that they would not have enough working capital to stay afloat and all three had to receive external financing (Chrysler and GM from the rescue and Ford from a line of credit).
More than three years after the rescue of Chrysler and GM, have the Big Three learned from their mistakes? So far, it appears that both Ford and GM have reduced their risk and financial leverage.
Ford:
2011
Assets
$ 178,350,000,000
Debt ratio:
91.55%
passive
$ 163,280,000,000
Capital
$ 15,070,000,000
GM:
2011
Assets
$ 144,600,000,000
Debt ratio:
73.04%
passive
$ 105,610,000,000
Capital
$ 38,990,000,000
Both Ford and GM improved their debt ratio. Ford cut its share by about 12 percent, while GM lowered its share by more than five percent. This has decreased your financial vulnerability if another global anomaly occurs that decreases demand within your industry and revenue is affected by this.
Both Ford and GM have also made strides to lower 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 The same share for GM decreased from 107.45% in 2009 to 87.78% in 2011. Given that it is unlikely that there have been significant advances in machinery or technology that drastically reduce unit production costs, it appears that both corporations have found a way to reduce your fixed costs, improving your operating leverage. . It is unknown whether Chrysler has fared better or worse after the bailout, as it is a private corporation and its finances are not made public.
Given that economic uncertainty is a challenge faced by all companies, it appears that Ford and GM have learned from the mistakes they made in the past. They have managed to reduce the risk in which they operate as well as change their operating model to better meet demand. Both Ford and GM have changed the types of cars they produce, moving to more economical and fuel-efficient models that are in demand, increasing revenues at both companies. It should also be noted that the increase in units sold and revenue can be attributed, at least in part, to the fact that many consumers are less afraid of buying Chrysler, Ford and GM models because there is a lower likelihood that their car orphaned. ; which means your car manufacturer will shut down and the customer will not be able to get service or parts for your car.
No one can predict the future. The Big Three’s revenue could skyrocket, plummet, or fall somewhere between the two in the next few years. Regardless of what happens, they have taken important steps to ensure that they will be protected from the mistakes they made in the past by lowering their risk when they made efforts to reduce their Liabilities and Fixed Costs to improve their Operating and Financial Leverage. as well as creating products that better meet the needs of potential customers. Hopefully, these business strategies will keep these American businesses going and American workers out of the welfare office.