understanding financial jargon
The ratio of a company's fixed assets to variable costs is called operational leverage (also known as operational gearing). For example, if a small firm has sales revenue of £1,000,000, fixed costs of £800,000 (e.g. staff wages and premises) and variable costs of 10% of sales (i.e. £100,000) then net profits are £100,000 (£1m - £800k - £100k). It has high operational leverage. If next year sales rise to £1,100,000 and fixed costs remain the same, variable costs will be £110k (10% of sales). The net profit is now £190,000 (£1.1m - £800k -£110k) which is an increse of 90% for just a 10% increase in sales.
However operational leverage can also work against a company's profits. If in the example above the sales had dropped by 10% to £900,000, the fixed costs would have stayed the same at £800,000 and the variable cost would have fallen slightly to £90,000. the net profit is now (£900k - £800k - £90k). The net profits have fallen by 90% based on a reduction in sales of just 10%.
With less operational leverage, a company's profits would be less exposed to a sales slump, but by the same token would be less sensitive to a sales increase.
What to do if you need more help
If you need more help with your specific commercial loan, mortgage or insurance requirement please speak to a professional financial adviser.
We hope you found this information useful.
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