Leverage: the driver of margin

• Global, South Africa
• Financial leverage, Leverage, Margin, Operating leverage
• October 27, 2020

Have you ever read a results announcement and wondered how revenue can grow by perhaps 7%, yet profit before tax somehow grows by 20%?

It seems like an innocuous question, yet the answer holds the key to why many companies are successful and others fail.

Top-line growth (i.e. revenue growth) is obviously important, but as revenue growth starts to reach maturity (a saturated market), operating and financial leverage become incredibly important.

These concepts are critical in driving a company’s margin.

[the_ad id=”3223″]

Always think about margin

I always look for margin expansion in any company that I analyse.

When margin is heading in the right direction, it shows that the company operates a cost structure that works well. This is known as “operating leverage” and reflects the extent of fixed vs. variable costs in a company.

Fixed costs drive margin expansion, because as revenue grows, fixed costs grow by inflation (rather than with reference to revenue). A simple example would be a head office lease which escalates at an annual rate that is unrelated to group revenue.

Here’s an illustrative example of operating leverage in action:

You can see from this example how fixed costs can “leverage up” the growth in operating profit, hence the term “operating leverage”.

A 20% growth in revenue suddenly becomes a 35% growth in operating profit. Operating margin improves by 380bps and shareholders celebrate as the share price usually rerates to trade at a higher multiple.

After operating leverage comes financial leverage

We’ve now bridged growth between revenue and operating profit, but what about operating profit to profit before tax?

Here’s another illustrative example which is a continuation of the previous example:

Financial leverage is a measure of how much debt is in the business. Assuming the debt balance stays constant and the interest rate doesn’t change, the interest cost won’t change either even though operating profit has grown so nicely.

The result is improved interest cover (operating profit dividend by interest costs) and amazing returns to shareholders, as profit before tax grows by 70%.

Remember, this was achieved by 20% growth in revenue.

[the_ad id=”3235″]

What goes up, can come down

Operating leverage and financial leverage can work in your favour but can also hurt you.

Here’s an illustrative example of how it can go wrong:

A 20% drop in revenue (common over lockdown) sends the company in a downward spiral to the point where it is barely profitable anymore.

Not only has the high fixed cost base become a major headache for the company, likely resulting in restructuring and job losses, but the interest costs are now at risk of not being serviced by profits. The company may have to start dipping into cash reserves just to service debt.

In these situations, companies often have to write-down (impair) assets to reflect the change in economic conditions, sending profit before tax into a significant loss position.

This is why companies with higher debt balances (like Sasol) take enormous pain in times of economic strife and report record losses.

Accounting rules don’t force a fixed vs. variable disclosure

There are endless pages of accounting rules designed to deal with every conceivable commercial situation, but companies aren’t compelled to disclose fixed vs. variable costs.

Analysts and investors have to use detailed supporting notes for expenses in the financial statements to calculate expense growth by type e.g. employee costs or occupation costs. This enables us to assess whether the company has an expense growth problem and where it might be.

It also allows for a reasonable approximation of how expenses might grow as the company grows.

Similarly, analysts must use the accounts to assess the levels of debt and interest payments, thereby measuring financial leverage.

This can become complicated in practice, but the important thing to understand is how a small percentage change in revenue (up or down) can be leveraged up into a far greater percentage change at profit level. CEOs and CFOs spend a lot of time managing expenses and the balance sheet in order to squeeze the best possible result out of growth in revenue.

[the_ad id=”3234″]