While positive on the global growth outlook, given financial and political challenges coupled with valuations at the upper end of historic trading ranges, investors should take the time to understand the cost structures of the companies they own.
Operating leverage, which is essentially the relationship between a company’s fixed and variable costs, can make a big difference to potential profit and cash flow. Fixed costs (eg. store rents, aircraft leases, loan repayments) are not dependent on the level of output/revenue, while variable costs (eg. commissions, freight, raw materials) change as the level of output/revenue changes.
The higher a company’s fixed costs compared to its variable costs, the higher its operating leverage, which means profits grow faster than sales. But because fixed costs must be paid even when output/revenue slows, profits and cash flows will also deteriorate much more quickly, making them susceptible to slowdowns in the business or economic cycle.
Operating leverage really is a double-edged sword. While economic conditions remain buoyant, companies with high fixed cost structures (eg. airlines, online businesses, utilities) can enjoy profit growth faster than revenue. However, in an economic downturn, companies with a greater variable cost structure can cut costs more quickly to better protect profits, as revenue declines.
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