Be wary of investing in companies with high operational gearing… Here’s why

Julie Brownlee, Fsp Invest, 21 Jan. 2015

Tags: operational gearing, what is operational gearing, financial gearing, investing, high operational gearing,

When you begin researching a company to invest in, there are many things to look at.

One thing you should have a look at is operational gearing.

If you invest in a company with high operational gearing and its business takes a turn for the worse, the effects could be devastating. Especially if the company has a high financial gearing too.

Read on to uncover what you need to know about operational gearing…

What is operational gearing?

Operational gearing is a way of measuring how sensitive a company’s trading profits are to changes in its turnover.

If you want to investigate a few specifics before investing, operational gearing is one to pay close attention to. It’s vital you understand the impact of operational gearing on a business.

Some companies have very high fixed costs. This means that regardless of how much money they bring in the door, they need to pay these costs.

Fixed costs include things like salaries and premises.

If a company has high fixed costs, it tends to have high operational gearing. A company with more variable costs, such as an online retailer, doesn’t have the same level of fixed costs to pay. Variable costs change along with the number of sales a company makes.

The impact of high fixed costs on operational gearing

Let’s have a look at an example to show the impact of high operational gearing…

Company ABC has sales of R100 million. Its fixed costs amount to R80 million. Its variable costs come in at R10 million.

This means its trading profit is R10 million (R100 million- R80 million – R10 million).

Let’s say business picks up. Company ABC’s sales rise 10%, taking them to R110 million.

Its fixed costs remain at R80 million. Its variable costs rise 10% to R11 million.

This means its trading profit is now R19 million (R110 million – R80 million – R11 million). That’s a rise of 90% in profit.

But, on the other hand, if sales fell 10%, trading profit would only be R1 million.

Why you should be wary of investing in companies with high operational gearing

When a business is doing well, investing in a company with high operational gearing can be a profitable venture. But if the business goes into a decline, things get very risky.

Be aware of companies with high operational gearing as well as high financial gearing. Financial gearing is a company’s borrowings relative to its shareholder equity. Combine these two factors and you have one risky company.

So there you have it. Why you should be wary of investing in companies with high operational gearing.

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