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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Operating Leverage

Posted by Muthu on January 4, 2014

I was going through a NFO material of IDFC mutual fund. No I’m not going to recommend that NFO. For that matter, I’m against all NFOs and have always advised you to avoid them irrespective of the fund house. It is wiser to invest only in funds with proven track record. But what I want to share with you is an illustration in that NFO material which would explain operating leverage.

When economy improves, companies which are under utilizing their capacities start moving towards full capacity resulting in enormous growth in earnings and return on equity. This growth in earnings and return on equity in turn gets reflected in price as price is slave of earnings.

Now let us see the illustration:

Ajay is the owner of a bus on Ramgarh- Sitapur route. The cost of one ticket is Rs.10. The bus has the capacity to carry 50 passengers but carry only 10 due to bad road.

So Ajay’s daily profit looks like this

Sales (10*Rs.10)-  Rs.100

Cost:

Driver            Rs.30

Fuel               Rs.50

Maintenance  Rs.10

Total Cost:               Rs.90

Profit:                       Rs.10

Ajay is not satisfied with the profit of only Rs.10 daily and assumes that the current conditions will prevail. He decides to sell out the bus service to a willing buyer, Vijay.

Vijay is confident that the road conditions would become better in future and hence buys the bus.

The road conditions do improve six months down the line.

The number of passengers increased to 30 per day still short of the full capacity of 50.

Now Vijay’s daily profit looks like this

Sales (30*Rs.10)-      Rs.300

 Cost:

 Driver          Rs.30

Fuel              Rs.50

Maintenance  Rs.10

Total Cost:                Rs.90

Profit:                       Rs.210

For 3 times increase in the passengers, the profit has increased by whopping 21 times.

This is known as operating leverage.

When the bus operates at full capacity of 50 passengers, the profit would be Rs.410.

41 times increase in profit for 5 times increase in revenues!! Again operating leverage in action.

As the economy improves, operating leverage would greatly help many companies as seen in the illustration above.

Thanks to IDFC MF for providing a simple and effective illustration.

3 Responses to “Operating Leverage”

  1. Shankarraju said

    Hi Muthu, Thanks for Sharing. It looks like if the economy improves good companies will be multi-bagger 🙂

  2. Kiran said

    Thanks for a great article.

    Which IDFC Fund was this?

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