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Operational Gearing: The Impact of Borrowed Money on Trading Profit

Operational gearing is a ratio that is designed to measure how sensitive profits are to sales revenue / turnover.

It measures change as a percentage and specifically, the change in trading profit which comes from a one percent change in sales revenue. Obviously, this also depends on the relationship between fixed and variable costs and profits.

Fixed costs are those that are incurred regardless of sales revenue and are also known as indirect costs. Variable costs are directly reated to sales revenue and are therefore often called direct costs.

Operational gearing = (Sales Revenue - Variable Costs) : Trading profit

or

Operational gearing = (Trading profit + Fixed Costs) : Trading profit

Within finance and the stock market more spefically, borrowings are often refered to as 'gearing'.

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This ratio means that the borrowed money acts as a multiplier. If performance increases, it will be magnified and results enhanced further. However, this means that the opposite is also true. If results deteriorate, the borrowed money will act as a weight and drag performance down even further.

In other words, borrowed money will either add an extra lever - or mutliplier - to profits. Depending upon trading performance, interest rates and the state of the economy, this can be either a good or a bad thing!

It is this 'lever' effect that causes borrowing to often be referred to as 'leverage'.

A great place to see the impact of this in an investment and corporate setting is by looking at the returns and results in the UK's investment trust market.

In the early years of this century, borrowed money was also used by traders to enhance their profits. Money would be borrowed at very low interest rates - often in Japan or America - and then invested elsewhere. As long as the invested return was above the rate of interest being charged then profits could be earned. This is known as the 'carry trade' and proved to be incredibly popular.

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However, as we all now know, too much borrowed money can be an incredible liability to an organisation. When lenders decided that they could no longer trust other lenders, the 2007 credit crunch forced many major financial institutions at almost no notice.

These banks, investment banks and funds could not refinance their borrowing and were therefore declared bankrupt. Therefore, whilst operational gearing can be used to enhance returns, the additional risk can prove to be fatal to a business.

Other fundamental analysis related pages include:

How To Use Risk Analysis To Make You A Better Investor

Why Low Risk Can Be Good

How To Use A Stop-Loss

Understanding Gearing And Borrowed Money

Liquidity Ratios: The Current Ratio and the Quick Ratio Explained

What Does The Return On Capital Employed (ROCE) Tell Us?

What Are Dividends?

Understanding A P/E Ratio (Price To Earnings Ratio)

Some Investment Definitions Explained

Why Selling Investments Is THE Most Important Skill You Can Learn In Investing

How Does Volatility, Standard Deviation and Beta Impact An Investment Portfolio?

What Is Alpha? Can You Outperform The Stock Market?

Learn How Beta And Volatility Impact Your Investment Portfolio

Does Correlation Influence Portfolio Diversification?