Operational Gearing: The Impact of Borrowed Money on Trading ProfitOperational 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'.
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.
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:
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