Looking to invest in a company? Check out its operational gearing first

Julie Brownlee, Fsp Invest, 13 Oct. 2014

Tags: operational gearing, what is operational gearing, investing, gearing, financial gearing, investing warning signs

It can feel like there’s a whole host of things to check out before you invest in a company to ensure you’re making the best decision.

If you’re looking to cut back on the research you do before investing, one aspect you shouldn’t scrimp on is a company’s operational gearing.

A company’s operational gearing can make a big difference to its profitability.

So what is operational gearing? And why is it so important?

Let’s take a closer look…

What is operational gearing?

A company’s operational gearing shows how sensitive it is to changes in its trading profits relative to changes in its turnover.

This is one vital aspect of a company’s finances you should check out before investing. You should make sure you have a clear understanding of this before parting with a cent.

Some companies have very high fixed costs. The company must pay these costs regardless of how much money the company makes. These costs include staff wages and premises.

If a company has very high fixed costs, it tends to have much higher operational gearing than those with more variable costs. A company with variable costs include Internet retailers.

Variable costs change up and down according to the level of sales a company has.

Operational gearing in action

Let’s have a look at an example…

Company ABC has sales of R100 million. It has fixed costs of R80 million. And it has variable costs of R10 million.

This gives the company a trading profit of R10 million (sales minus costs).

If Company ABC’s sales rise by 10% to R110 million, its fixed costs remain the same at R80 million. Its variable costs rise by 10% to R11 million.

That means its trading profit increases to R19 million. That’s a 90% increase.

But if Company ABC saw its sales fall by 10% to R90 million, profits would almost disappear.

Why operational gearing matters

If you buy companies with high operational gearing when times are good, these companies can be very profitable.

But if times are bad, these companies struggle. And this means your investment is more high risk.

If a company has a lot of borrowings relative to its shareholder equity, it has high financial gearing. If this company has high operational gearing too, this can be a lethal mix.

So there you have it, why you should check out a company’s operational gearing before you invest.

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