Operational leverage

28th Jul '16 by Jonny shares

7 comments 4746 reads

I recently been looking into operational leverage and being honest I haven't quite grasped the concept , therefore I wold love to know other peoples take on it? for example how important is it when considering a stock? What is a ideal ratio ? and how can you calculate it using stockopedia financials?

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About the Author

Jonny Shares

Premium Member

7 comments

VegPatch

29th Jul '16

very important
One of the biggest lessons i was taught early on by a top performing fund manager was never to mix a highly operationally geared company with excess debt. It usually ends badly.

As to operational leverage itself, it is how an increase / decrease in the top line (ie revenue) translates into profits. A quick way is to compare gross margins to EBIT margins. The higher the differential the more operationally geared the company is likely to be.

Ramridge

29th Jul '16

Jonny -
In case you are not aware, it is important to distinguish between balance sheet gearing and operational gearing.

I could give you some explanations but TBH there is an excellent website, investopedia.com, which will give you a whole lot of explanations and examples as well. It is a kind of wikipedia for investment topics.

Carcosa

29th Jul '16

As Ramridge stated, have a look at investopedia.com for a good explanation.

As with any financial ratio you cannot rely on a single measurement in isolation.

A company with high operational leverage, can have extraordinary profit growth for a modest increase in sales/revenue. These are the sort of companies many investors want to see. Problems often arise when those revenue increases start to flatten out or decline. As powerful as high operational gearing can be with modest revenue growth it is similarly destructive when revenues start to decline. If, as VegPatch alluded to, the company has been expanding with the use of excessive debt then the company will not only have to endure operational losses but they will also be hurt by having to service that debt too. Often you will find such a company will go bust. Highly operationally geared companies are like shooting stars; very nice to begin with but the party is over very quickly.

So, for highly operationally leveraged companies you are ideally wanting to see a product or service that competitors will have a hard time re-producing to maintain pricing power. Frequently such companies are bulletin board darlings and unrealistic expectations about their future growth is assumed.

Frequently such companies also have very high P/E values. Often you will see such companies lose 20-50% of the shareprice the moment negative news about the company is known. And shortly thereafter they go bankrupt.

You can make a small fortune on investing in such companies but the moment revenue starts to deteriorate it is often wise to sell up and move along.

biloseli

29th Jul '16

This is a good question to ask. I think the best way to understand the importance of operational gearing is to make a simple spreadsheet and play with the numbers.

Let's think about an over-simplified company. Company A rents a single building with a factory that makes bicycles to order at the back and a showroom for customers at the front. The government wants everyone to ride bicycles, so the company operates tax-free. It has fixed costs of £2m a year to pay for the building, maintaining the factory, paying staff, etc. Each bicycle it sells for £1000 costs £750 to make, so each bicycle only adds £250 to gross profit. That means it has a 25% gross margin. It makes £10m in revenue a year. It pays out all its net profits as dividends. Every year the numbers are the same.

We can make a spreadsheet model of this company:

Revenue = £10m
Gross margin = 25%
Gross profit = [Revenue] * [Gross margin] = £2.5m
Fixed costs = £2m
Net profit = [Gross profit] - [Fixed costs] = £0.5m

I'm not taking tax or lots of other things into account. The idea here is just to explore the operational gearing relationship.

The company announces in a trading update that it's expecting a 10% increase in revenue this year. The share price shoots up a lot more than 10%. Why? Putting the numbers into the spreadsheet:

Revenue = £11m (+10%)
Gross margin = 25%
Gross profit = [Revenue] * [Gross margin] = £2.75m (+10%)
Fixed costs = £2m
Net profit = [Gross profit] - [Fixed costs] = £0.75m (+50%)

Net profit has shot up by 50%! The market is now expecting a bumper dividend this year and is bidding up the share price.

What if it had announced a 20% decrease in revenue? There is no profit at all (even though the company made £8m revenue) and the dividend will have to be stopped. Income investors will probably sell their shares in droves, forcing the share price down. If revenue goes lower than £8m this company will make a loss.

Having failed to get into Company A shares before it announced the revenue increase, you discover Company B also makes bicycles, also has a 25% margin and also has £2m in fixed costs. The only difference is it makes £50m revenue a year. It's bigger and better. You reckon it could benefit from growth in the custom-made bicycle market too, so you buy the shares which have recently risen a bit. You think they could have much further to go.

Company B also announces a 10% increase in revenue, but the shares hardly move. What happened? Let's look at the situation before the announcement:

Revenue = £50m
Gross margin = 25%
Gross profit = [Revenue] * [Gross margin] = £12.5m
Fixed costs = £2m
Net profit = [Gross profit] - [Fixed costs] = £10.5m

After the announcement:

Revenue = £55m (+10%)
Gross margin = 25%
Gross profit = [Revenue] * [Gross margin] = £13.75m (+10%)
Fixed costs = £2m
Net profit = [Gross profit] - [Fixed costs] = £11.75m (+12%)

The market had already priced in most of the 12% profit growth before you bought the shares. To get a 50% rise in net profits, Company B would need £71m in revenue - a 42% increase.

It's well worth making a spreadsheet and experimenting with the numbers, because even though the maths is easy, the gearing effect isn't intuitive. I hope this illustrates the points made in the other replies. I'm fairly new to investing, so I also hope it's right! Corrections welcome.

Jonny shares

29th Jul '16

Thanks all of you for the response all very informative. Vegpatch, so regarding margins are you saying a company with higher op margin say (20%) to say (5% net margin ) would be highly susceptible or the other way round?

VegPatch

2nd Aug '16

Hi,
apologies for the delayed response. I had written a reply but didnt finish it, then got distracted by kids...the rest is history.

Anyway, in response to your question. It is the relationship between gross margins and operating (EBIT) margins. Consider 2 companies. The first is a software company with GMs of say 90% and EBIT margins of 45%. The Gross margins tend to stay stable in the short term despite the volume produced. So if customers increase from 1 to 2, GMs remain at 90%, and it sells 2 units at £100 each, then revenue rises from £100 to £200. Gross profit goes from £90 to £180. Assuming all labour costs (£40) and rents (£5) are fixed in the short run, ie we assume the company has spare capacity to deal with this doubling of demand, then profits rise from £45, to £135. If we calculate the ratio of the GMs (90%) to EBIT Margins (45%) we get a ratio of 2 (ie 90/45 = 2). So in our example a rise in sales of 100% boosts profits from £45 to £135, or 200%.

But then we must compare the software company with other companies to see which is more operationally geared. Using the same maths but for a widget maker (pretty competitive space given all those low cost far east competitors!). it sells 100 widgets a year at £1 each. Revenue is therefore £100 and assuming GMs of 40%, labour of £25 (25% of sales) and rent of 5%, the widget company makes £10 per year, or EBIT margins of 10%. Miraculously they receive a monster order which doubles sales to £200. GMs remain fixed at 40%, so Gross profit doubles from £40 to £80. Labour is able to cope with the extra orders (fantasy I know) so stays at £25 and rent is static at £5/yr. Suddenly EBIT goes from £10 to £50, and EBIT margins rise from 10% to 25%. In this case the relationship between gross margins (40%) and EBIT margins (10%) is 4 (ie 40/10 = 4).

So we can see the greater the ratio between gross margins and EBIT margins, the more operationally geared a company can considered to be.

VegPatch

2nd Aug '16

Company A: sells software
Units sold	1	2
Price per unit	100	100
Revenue	100	200

Gross Profit	90	180
Gross Margins	90%	90%

Labour	-40	-40
Labour as % sales	40%	20%

Rent	-5	-5
Rent as % of sales	5%	2.5%

EBIT	45	135
EBIT Margins	0.45	0.675
Profit uplift		300%

Ratio of GM to EBIT Margin		2

Company B: sells widgets
Units sold	100	200
Price per unit	1	1
Revenue	100	200

Gross Profit	40	80
Gross Margins	40%	40%

Labour	-25	-25
Labour as % sales	25%	13%

Rent	-5	-5
Rent as % of sales	5%	2.5%

EBIT	10	50
EBIT Margins	10%	25%
Profit uplift		500%

Ratio of GM to EBIT Margin		4

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Operational leverage

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Jonny Shares

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