What does operating leverage refer to?

Operating leverage refers to the degree to which a firm utilizes fixed costs in its operations. A company with high operating leverage will experience greater fluctuations in profits due to changes in sales volumes, because a larger proportion of its costs are fixed rather than variable. This means that when sales increase, profits can rise substantially, but conversely, if sales decline, losses can also amplify.

Understanding operating leverage is crucial for businesses as it helps assess risk and make informed decisions related to pricing, investment, and production levels. Companies with lower operating leverage, on the other hand, rely more heavily on variable costs, which can provide more flexibility in managing expenses in response to fluctuating sales, but may not benefit as much from increased sales in terms of profit margins.

The other options, while related to financial concepts, do not accurately define operating leverage. The strategy of increasing sales to cover variable costs, the overall profitability assessment of a company, and cash flow management techniques focus on different aspects of financial management rather than the specific relationship between fixed costs and sales volume, which is at the heart of operating leverage.