Corporate Finance, 4th Edition

Chapter 10Margin analysis: risks

Costs are not like problems, people do not like them to be fixed

In Chapter 9, we compared the respective growth rates of revenues and costs. In this chapter, we will compare all company costs and key profit indicators as a percentage of sales (or production for companies that experience major swings in their inventories of finished goods and work in progress).

The purpose of this analysis is to avoid extrapolating into the future the rate of earnings growth recorded in the past. Just because profits grew by 30% p.a. for two years as a result of a number of factors, does not mean they will necessarily keep growing at the same pace going forward.

Earnings and sales may not grow at the same pace owing to the following factors:

• structural changes in production;
• the scissors effect (see Chapter 9);
• simply a cyclical effect accentuated by the company's cost structure. This is what we will be examining in more detail in this chapter.

Section 10.1 How operating leverage works

Operating leverage links variation in activity (measured by sales) with changes in result (either operating profit or net income). Operating leverage depends on the level and nature of the breakeven point.

1/ Definition

Breakeven is the level of activity at which total revenue covers total costs. With business running at this level, earnings are thus zero.

Put another way:

• if the company does not reach breakeven (i.e. insufficient sales), the company posts losses;
• if sales ...