The Ins And Outs Of Operational Leverage

When a company’s profits increase at a faster rate than its revenue, it has leverage. But how does this occur?

- Simon Brown

 

Operational leverage is one of the beauties of investing. That occurs when companies are able to increase profits at a faster rate than they’re increasing revenue. The cherry on the top is when dividends are able to increase at a still faster rate than both revenue and profits.

Which sectors can benefit from operational leverage?

The easiest example of this can be found in any fixed cost business, such as a mining company. The cost of extracting whatever it mines from the ground is relatively fixed, with adjustments for inflation. But the payment it receives for whatever it mines could be increasing at a faster rate than inflation is driving costs up. When this happens, the revenue will increase, but profits (and potentially dividends) will soar as most of the extra revenue goes straight to the profit line.