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Key Takeaways:
- Operational gearing refers to the ratio of a company’s fixed costs to its variable costs, indicating its risk exposure due to changes in revenues.
- Companies with higher operational gearing have higher profit growth with growing revenues, but profits shrink faster when revenues decline.
- Understanding a company’s operational gearing can help investors gauge the business risk and potential for sustainable profits.
- An assessment of operational gearing should include an examination of past performance, especially during economic downturns.
- Operational gearing does not always stem from business volume changes but can also arise from alterations in the selling price of a product or service.
Decoding Operational Gearing: Understanding Business Risk
In the realm of investments, business risk is unavoidable and understanding it becomes crucial for successful investing. It is as much about avoiding the losers as picking winners. A significant element that contributes to business risk is the relationship between a company’s revenues and its costs, otherwise known as operational gearing.
Operational gearing can be defined as the sensitivity of a company’s operating profits to a 1 per cent change in its revenues. If a company’s change in profits is significantly sensitive to changes in revenue, it means that its profits are highly operationally geared. Delving into the concept of operational gearing is paramount for investors, as it aids in understanding if a company’s fast-growing profits are sustainable or not.
Fixed Costs vs Variable Costs: The Backbone of Operational Gearing
At the core of operational gearing lie two types of costs: fixed and variable. Fixed costs are the expenses that a company has to bear regardless of the level of revenues. These costs remain constant and could include rent, salaries, and utilities. On the other hand, variable costs fluctuate with the level of revenues, such as costs incurred for raw materials, production, and distribution.
Businesses with a larger share of fixed costs are more operationally geared. This includes transport companies, manufacturers, or service companies with a large workforce. In contrast, companies with mainly variable costs, like retailers who buy and sell products, exhibit low operational gearing.
Operational Gearing: A Double-Edged Sword
Operational gearing can act as a double-edged sword. While high operational gearing can drive rapid profit growth in times of increasing revenues, it can also cause profits to plummet at a faster rate when revenues decline. This makes high operationally geared companies potentially risky investments, especially if their revenues are volatile.
For example, if a company with high operational gearing sees a 10 per cent increase in revenues, it may lead to an 80 per cent increase in operating profits. However, the reverse is also true. A 10 per cent reduction in revenues could lead to an 80 per cent reduction in operating profits.
On the flip side, companies with lower operational gearing do not experience the same fluctuations. Their profits might not rise as much when revenues grow, but they do not decrease as much when revenues fall. This makes these companies less risky from an investor’s perspective.
The Operational Gearing Ratio: A Crucial Calculation
The operational gearing ratio can be calculated by dividing a company’s contribution (revenue less variable costs) by its operating profit, or by adding the fixed costs to the operating profit and dividing the result by the operating profit. This ratio provides a numeric representation of the company’s operational gearing, helping investors to gauge the impact of changes in revenue on the company’s profits.
Historical Trends and Operational Gearing
Though it might be challenging for external investors to precisely calculate a company’s operational gearing due to the lack of detailed cost data, historical trends can provide invaluable insights. Investors can study how a company performed during the last recession, focusing on any large operational gearing effects.
Unless the business has undergone significant changes since then, there’s a high chance that history could repeat itself during the next downturn. These past changes in revenues and profits can give investors a sense of the operational gearing that might exist within the business.
Operational Gearing and Price Fluctuations
Operational gearing effects are not limited to changes in business volumes; they can also originate from alterations in the selling price of a product or service. This is often evident in industries such as airlines, where prices can significantly vary based on industry demand and supply. Given the industry’s high fixed cost base, profits can be very volatile.
Conclusion: The Importance of Operational Gearing in Investments
Operational gearing is an essential concept for investors to understand before committing to investments. It provides a lens to gauge the potential risks and rewards associated with a company’s performance based on its revenue-cost relationship. By understanding a company’s operational gearing, investors can make more informed decisions and potentially steer clear of risky investments, all while spotting potential winners. Hence, knowledge of operational gearing is a powerful tool in the investor’s arsenal, shaping their success in the unpredictable world of investments.
