Why you should check out a company’s operational gearing before investing

Julie Brownlee, Fsp Invest, 30 Jun. 2015

Tags: operational gearing, what is operational gearing, how to use operational gearing, investing, profitability,



When finding shares to invest in, there are a number of things you need to delve into before you buy.

One thing you should be checking is operational gearing.

So what is operational gearing? What difference does operational gearing make? And how can I check a company’s operational gearing?

Read on to find out…



What is operational gearing?


Operational gearing is how sensitive a company’s trading profits are to fluctuations in its turnover.

Companies have costs. Depending on the type of business the company is in, costs will differ.

Some companies have high fixed costs. A company must pay these costs regardless of the money it makes. Fixed costs include rent for property and salaries for staff.

Companies with high fixed costs tend to have higher operational gearing than companies with more variable costs.

As the name suggests, variable costs change. They go up and they go down.

Let’s look at an example to show the impact of operational gearing on a company with high costs.


High operational gearing can be dangerous


Company ABC makes sales worth R200 million. Its fixed costs come in at R160 million. And its variable costs are R20 million.

This gives you a trading profit of R20 million (R200 million – R160 million – R20 million).

If sales rise by 10%, they come in at R220 million. Fixed costs stay the same. Variable costs rise in line with sales to R22 million.

This leads trading profit to rise to R38 million (R220 million – R160 million – R22 million). That’s a 90% increase in trading profits.

But if sales fall 10% to R180 million, trading profits fall to R2 million (R180 million – R160 million – R18 million).

It’s worthwhile checking a company’s operational gearing out before investing.

When times are good, investing in a company with high operational gearing is profitable. But when times are tough, a company with high operational gearing can struggle.

So there you have it. Why you should check out a company’s operational gearing before investing.

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