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Navigating Black Swan Events

Ever seen a black swan? The term was coined by Nassim Nicholas Taleb. A finance professor and former Wall Street Trader, Taleb created the term in his book, “The Black Swan”. It describes a situation that is both unexpected and hard to predict. Events like 9/11, Brexit, and natural events (like an earthquake) have caused people to question if it was a black swan event. Before we look at how companies should be navigating black swan events, let’s identify what black swan events are.

What Are “Black Swan Events”?

The most important question being asked is “what are black swan events?” A black swan event must have following three attributes:

  1. The event is extremely difficult to predict (at least to the observer)
  2. The event carries a major impact
  3. After the event has occurred, people will try to make it explainable and predictable (hindsight bias)

Black swan events might include the Asian Financial Crisis of 1997, Global Financial Crisis 2008, Oil Crisis 2014, to the more recent Brexit in 2016. Taleb states that a black swan event depends on the observer. For example, the Thanksgiving turkey sees his demise as a black swan, but the butcher does not.

Somehow, it’s confusing to call a black swan event a crisis and the other way around. Furthermore, not all black swan events are crises and not all crises are black swan events. 

Origin of a Black Swan

Taleb’s theory started from the Western belief that all swans are white. Until the year 1967, the Dutch explorer discovered the black swans in Australia. It was beyond normal expectation and profoundly changed zoology. Since then, the term “black swan” has been used to describe situations where impossibilities have been disproven and the risk effects when it happens.

Characteristics of Black Swans

In order to determine whether the Brexit event is a black swan, you would want to know the characteristics of black swans. Let’s examine all 3 attributes – unpredictability, widespread effect, and hindsight bias.


If you know the characteristics of Black Swans, start protecting your company by analyzing it internally. Click the button to download the Internal Analysis whitepaper to enhance strengths and resolve weaknesses.

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Unpredictability

Did the Brexit panic surprise you? What really makes Brexit unpredictable?

Brexit posed a huge challenge to the future of EU in general and specifically, the United Kingdom. Furthermore, Brexit led to a significant increase in power and responsibilities for local institutions. This would only add to the instability of EU.

Widespread Effect

Does it have a domino effect on all EU members states exits? Why is Brexit such a major trigger event?

Brits had been as a dominant country inside the EU, and it was argued that EU couldn’t exist in its current form without London playing a major role in the financial field. Brexit put EU in shock. Within a day, over 10,000 jobs were lost in the banks. Tariffs hikes the prices of automobiles. Inflation spiked. The effects of this event will be felt by everyone. It’s just a matter of when. 

Hindsight Bias

And now that it’s all over, some people have fallen into hindsight bias, known as a know-it-all-along effect. Brexit is widely thought as a natural expression of concern over immigration. So, is the recent Brexit truly a black swan event?  Your answer will likely depend upon your situation, but based upon the criteria set forth by Taleb, one could certainly make the case that it is.

Navigating Black Swan Events

How can we as financial leaders avoid becoming the Thanksgiving turkey? Taleb suggests that when navigating black swan events, you do not attempt to predict the unpredictable. Instead, Taleb iterates that our time would be better spent preparing for the aftermath or impact of negative black swan events and position ourselves to exploit the positive black swan events.

Think about preparing for negative events as just managing your business through the valleys. Since there is no certain way to determine how long the valley or trough will last, design a plan that considers possible durations (3 months, 6 months, 1 year, 2 years, 5 years, etc.). If the crisis resolves in 6 months, then what steps do you need to take? What if it’s longer? What if there is no foreseeable end in sight? How will those durations impact your financials (revenue projections, cash flow projections, etc.)? How much overhead can you have through these stages?

Where do you start when developing these scenarios and action plans? You need to seriously evaluate your key performance indicators (KPIs) to determine what you should be focusing on. Obviously, know the major KPIs in your industry. If you do not know them already, talk to key customers, investigate what competitors are using, and research benchmarks. After you have identified those KPIs, track and analyze any variance by utilizing trend tools, breakeven analyses, and what-if scenarios.

Take your plan and break it down into steps based on the different durations. You do not want to risk cutting too deeply because you need resources available to take advantage of when things turn around.

Strategies for Managing Black Swan Events

When navigating black swan events, it is important to note that crises provide a unique opportunity to get your house in order. Unfortunately, businesses have a habit of making rash decisions (and bad decisions) because everything is moving so quickly. They don’t identify how bad those decisions were until things start going downhill. As a result, there’s a lot of clean up to do during downturns. Think about Warren Buffett’s famous phrase, “You never know who’s swimming naked until the time goes out.”

What are some steps you can take to manage these downturns? Here are some ideas…

Weed the Garden

Start by weeding the garden or removing those unnecessary costs (i.e. overhead expenses). Overhead costs can easily get out of hand with revenue. Unfortunately, they tend to not decline as quickly when the sales drop off. Analyze your cost structure to convert more cost to variable vs. fixed. This will make sure that costs will stay consistent with volume.

Another method to weed the garden is to fix any hiring mistakes. You have a commitment to continue the business for your employees. Remove the people that don’t fit and don’t add value. When things pick back up, you will be better prepared to take on the right fit.

Look internally at your company. Analyze each part of your company and then make strategic decisions. Use our Internal Analysis to get started.

Finally, analyze your products and services. Compare their profitability. Remove those that are either unprofitable or not as profitable as the other products. Reallocate those resources to the products and services that perform better.

Do More With Less

Your company will always benefit from improving its productivity. However, it’s different for every business. Use the following formula to identify how you can improve your operations:

Productivity = Throughput ÷ Resource

When you discover the throughput and resources for your business, you can discover how to use less resource and generate greater throughput. This will improve productivity and therefore, profitability. With not as many sales, it’s a great time to evaluate your operations.

Reduce Leverage

During times of uncertainty, reducing leverage is especially critical. A few decades ago, a debt to equity ratio greater than 3:1 was considered high risk. Today, a risky investment is a debt to equity ratio greater than 4:1. Because of the speed and availability of information becoming more accessible, company’s comfort level with risk increases. However, this can increase the number of problems when negative surprises or black swans occur.

React Quickly

One of the biggest mistakes the company should avoid is that reacting too slowly. From a business perspective, you would want to react to new opportunities and then make decision quickly. Same thing with threats… Address those threats immediately and don’t delay on reacting.

Have you ever heard of the boiling frog analogy? A chef does not just throw a frog into boiling water. The frog would immediately jump out because it’s hot. To fool the frog, you put the frog in cool water and slowly turn up the heat. This incremental increase in temperature is hard to notice when inside the water. Don’t be the frog.

Have you identified the strengths and weaknesses in your company that you could either enhance or reduce respectively? If not, now’s the time! Access our Internal Analysis to get started.

Prepare

Based on the historical events that people come up with a preparation plan for upcoming disasters. This is what people do when it’s over. Analyze the situation and think of how we can avoid negative impacts or at least assess the risk of losses. If you think a black swan would cause you panic, then assess your attitude toward risks. By understanding that, you would know what type of investment to hold a long-term plan. One of the options for long-term investment can be assets, stocks, etc., even though they’re riskier but they come with high rewards. This is your time to consider what your company can do better when your sales are falling.

Avoid Pessimism

The main idea of a Black Swan is not to attempt to predict black swan event, but rather concentrate on guarding against its unpredicted effects. In an organization, especially risk managers, knowing that you have a plan for it will help you gain confidence to take advantage of any black swan events in the future.

When navigating black swan events, it’s a great opportunity to look under the hood. Take a look internally. Access our Internal Analysis whitepaper to assist your leadership decisions and create the roadmap for your company’s success!

Navigating Black Swan Events
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Navigating Black Swan Events

(Adapted from Jim Wilkinson’s article found here.)

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5 Signs It’s Time to Restructure Your Company 

signs it's time to restructure your companyOver the course of my 28+ years of financial experience, I’ve had a number of restructuring transactions. What I have found is that many companies do not know when it’s time to restructure their company. Instead, they wait until it’s too late and it becomes a liquidation event.  Restructuring can mean different things, there are restructuring engagements that take place through the legal system such as bankruptcy, and there are out-of-court restructuring.  In this blog when I mention “restructuring,” I am referring to out-of-court restructuring. In this week’s blog, we’re looking at the 5 signs it’s time to restructure your company.

What is Restructuring?

Restructuring is when you change internal operations processes, positioning in the marketplace, restructure debt, modify your operations and work towards becoming a more profitable and cash flow positive business. There are several reasons why companies undergo restructuring.  Usually, they are feeling a financial pinch. Most business leaders actually wait to long to restructure their business. In 2014 with the fall in oil prices, I actually saw companies with direct impact wait to make any changes. Those that saw the writing on the wall and took aggressive action early on are the ones that survived. Whenever you see external or internal factors affecting your cash flow and financial performance, you need to take a hard look at them and do not wait to make changes.

Several of the signs its time to restructure are also destroyers of value. If you are crafting your exit strategy now, then download our Top 10 Destroyers of Value to make sure you don’t leave any money on the table.

Signs It’s Time to Restructure Your Company

Now, you know what restructuring is. The next question is… When? There are several signs it’s time to restructure your company, but we’re going to look at the top 5 indicators that things need to change.

signs it's time to restructure your company

1. Trends Are Not Looking Good

Hopefully you have dashboards in place and financial reports that allow you to track trends such as your trailing twelve months margins, ratios and a 13 week cash flow forecast in addition to an annual budget. If these tools are painting a picture that your business is not performing, then corrective action should take place sooner than later.  If after your corrective actions, the trends are still negative, then you may consider a broader restructuring of your business.

2. Over-Leveraged

For the past 10 years, the cost of money has been cheap. Banks, asset-based lenders, and investors are all looking to place money to work. With low interest rates and excess liquidity, companies have had access to cash in the form of debt. Debt is not all that bad if it is managed wisely and you do not exceed the amount of debt that your balance sheet can handle. The ease of acquiring debt has led to some companies having to much debt  – over-leveraged.

What is too much debt? Well it depends on your business and your balance sheet. Commercial banks have the most conservative ratios, but I would say that even some of those may lead to too much debt. If you have too much debt, then you may find yourself needing to restructure your company. If the debt is more than you can pay, then you will likely find yourself in a legal reorganization, such as court protection through a bankruptcy process.

An investor will not invest in a company that has too much debt. If you are seeking investment, financing, or want to sell, then learn about the Top 10 Destroyers of Value.

3. Changing Markets

I can think of two current markets that have changed or are changing today. If you are in these either of these markets, then you will need to consider restructuring your business. The first is the retail real estate market businesses that own malls or large shopping centers. Online sales have totally changed this market. Large department stores are disappearing as more and more retail customers are shopping online. Owners of malls in many areas are having to restructure their business and find alternate uses for the real estate. The second is the off-shore oil and gas industry. This sector has not recovered yet, and it is going to be a long haul. Boat companies, offshore suppliers, and service companies are having to come up with a new way to survive.

If you find yourself in a market that is either disappearing or dramatically shrinking, then you need to take drastic action and restructure your business. If it is a permanent change in the market, such as the market change of renting movies to Netflix, then you may find yourself in the same position as Blockbuster which just disappeared. Hopefully, the executives and your Board of Directors have a keen eye on the markets you are in and how technology is affecting them.

4. Environmental & Technology

The world has become smarter about taking care of our environment. Technology is helping us do this more and more efficiently. 20 years go, an electric car was more of a concept only and cost prohibitive from a manufacturing standpoint. Today, there are several cars in the market that are more affordable and manufacturers are bringing prices down every year and new models coming out.  The major automakers know this and are planning ahead.  For 100 years now, cars have run on on oil based products. If your business is tied to gasoline engines, hopefully you are looking to restructure your manufacturing or market. The environment can also bring major changes. Do not think of just taking care of the environment versus pollution, but bad weather can also force you to change. Sometimes, for the better. I was talking to a client recently in the mid west part of the country. They can not find contractors to fix roofs because they are all down in the Gulf Coast.  How about a new roofing business in the mid west? They continue to have the need.

signs it's time to restructure your company

5. Regulatory Environment

Government is getting bigger and bigger. Every year, there are more and more regulations changing how the business world operates. If you are in a market that has new regulations, then this may be something that will cause you to change how you operate. You may find yourself restructuring your business to either adapt to the new regulations. Or you may find your self restructuring your business to get away from the regulated environment.

Protect Your Company From Destroyers of Value

Restructuring your company protects your company from destroyers of value; however, you should always be looking at how to improve the value of your company. Locate other areas that are destroying the value of your company with our free Top 10 Destroyers of Value whitepaper.

signs it's time to restructure your company

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Key Elements When Seeking Financing

key elements when seeking financing

This past week, one of my clients met with a banker to develop a new banking relationship. He hands the banker the company’s financial statements, expecting the banker to look at the income statement. Instead, the banker flips to the back of the financial statements to look over the balance sheet. As the coach, I asked my client, “See what he just did?” Most financial leaders (and the owners of their businesses) are consumed with their income statement but the banks want to know are more interested in how leveraged their banking client is. Not surprisingly, there are a few key elements when seeking financing for companies to follow.

Key Elements When Seeking Financing

Every company cycles through good and bad times. Depending on what part of the cycle your company is currently in, your banking relationship may be influenced. There are some key elements when seeking financing that will keep you on the good side of your banker.
Identifying your KPIs is a critical piece of the process when seeking financing. Want to find your KPIs and learn how to track them? Access your free KPI Discovery Cheatsheet today!

Leverage

What is leverage? Financial leverage is the use of borrowing from the bank to offset the cost of sales. Many companies hope to borrow just enough to increase their capabilities to sell more. But if banks see that you are too highly-leveraged, it’s bad news!

As a key element when seeking financing, leverage is important to have as it provides credibility to your borrowing experience. A banker will see that you have maximized the potential of previous capital to increase sales. The “kicker” here is if you have failed to optimize the borrowed capital potential, then the bank is going to be more prone to backing out of (or not starting in the first place) a banking relationship with you.

Cash Flow

We say it often and we say it loud… Cash is king. Without cash and/or liquid assets in your company, the bank is going to turn its nose up at you. Be sure to communicate the availability of cash in your company. For example, if a friend asked you for $250,000 but had no way of paying you back, you would be wary and decline the ask. This is because there is no hope that you will get the money back that you loaned. The bank acts in its best interest.

Make it easy for the bank to make a decision. Communicate through the financial statements (especially the balance sheet) the availability of cash.

Not About Price

Oftentimes, business leaders think that the bank cares about the price of your product. They don’t. To the bank, price is the least important factor in their assessment of your company because money is a commodity to them. Price is immaterial.

When meeting with a banker, communicate the bottom line and what’s on the financial statements NOT how you price your product. The bank is not your business consultant. They have to make money off of you.

Creating a Banking Relationship

When seeking financing, it is essential to create a banking relationship. You wouldn’t get married to the person you passed by on the sidewalk, so why would you get into a banking relationship with someone you have zero connection with. There are a few things that you need to look for to have a successful banking relationship.

What to Look For

If you are just starting out in a new city or have no relationships with any bankers, one of the first things that you can do is connect with people that do! For example, as a consultant, I have multiple relationships with various banks. When one of my clients needs a banker, I make the connection. People love feeling like they have it all, so give them the benefit and ask for help.
key elements when seeking financingLook at the bank for their philosophy and how they take care for their customers. In addition to philosophy, look at their morals.
Some questions to ask your banker in the “dating” stage include:
  • How long is a typical relationship with your customers?
  • What are the communication boundaries?
  • What is the bank’s view of breaking debt covenants?

Relationship or Transaction

Another important question you need to ask yourself is: “is this bank looking for a relationship or a transaction?” If you answer the latter, then you are just commission to them. When times are rough, you’re going to get cut. But if the answer is a relationship, then you’re looking at a long healthy marriage.

Relationships are absolutely critical in business. Value these relationships and take care of people. It will reflect in your business.

How does the bank deal in times of crisis?

A few years ago, I had a client that went through a period of stress. In the last quarter of their fiscal year, the business was growing and was doing well. They had 4 quarters of decline, but had tracked their KPIs. Although they had broken a few debt covenants, they were tracking their progress carefully with the bank. This client had a strong relationship with their bank. Without that relationship, the bank would have taken my client to the “workout” group.
Don’t have KPIs to help your banking relationship? Learn how to identify your KPIs and how to track them with our free KPI Discovery Cheatsheet. Click here to download your cheatsheet!
When you stub your toe, how does your bank react? Are they willing to let you slide on debt covenants for a few quarters as long as you have a plan to get out of the downturn? Often, people don’t see the importance of knowing how your bank is going to react in times of crisis. The economy continually ebbs and flows, changing for good or for bad.
Also, how does the bank deal with growth? You need more financing, but you are breaking covenants. Are they willing to provide financing with the knowledge that things won’t pick up immediately?

 The Workout Group

Several years ago, the bank wanted to meet with another of my clients because they had broken their debt covenants. The client calls me after meeting with “great news”! He said that the Bank had offered to work out his problems in the workout group. This “workout” group isn’t to work out your problems and put you back on track. It’s to work you out of the bank. This is not a good thing.
You don’t think your house will ever burn down, but what happens if your house does burn down? You don’t think you need a bank to weather the storm, but what happens when you need the bank to weather the storm with you? Assess whether or not your current banking relationship will be your insurance in the case of a fire or storm.
One way to do this is to look at the bank’s philosophy of business and their internal culture. How tight are they with the rules? Are they willing to stretch a little on their debt covenants and step up to help in times of distress? My client’s bank was unwilling to stretch its debt covenants. Instead the bank just wanted to wipe their hands clean of my client and move on to the next sale.
This willingness to be flexible all boils down to relationships. I have to warn you though, not every bank is similar in their goals.

key elements when seeking financingGet in Line

To prevent being put into the “workout” group, it’s crucial to start out on the same page. Get an alignment of interests, philosophies, culture, and anything else that would impact your company.

Interest and Philosophies

If the bank is only interested in their bottom line, then it may not be a good fit. If the bank is truly invested in your company and is willing to help you out in any reasonable way, then it’s a perfect match.

As I’ve built The Strategic CFO, it’s been a priority of mine to create relationships with bankers as they are going to reap the benefits of my clients doing business with them and I value their expertise. As a result of our mutual interests, the bankers in my network continually push potential clients towards my consulting practice. Those bankers and I have a strong relationship where we understand each others’ needs and desires as well as feed each other.
Of course though, I have had bankers tried to take advantage of my generosity and not return the favor. As a result, those relationships did not last long. It’s all about getting ones’ interests and philosophies in line.

KPIs That Influence Debt Covenants

Banks monitor your debt covenants. To help them (and you) out, identify KPIs that influence debt covenants to help track where you are and where you’re going. Picture this, your significant other or spouse comes home and lets you know that they’ve purchased a house, car, and boat without ever discussing it with you before. If you’re like me, I’d be surprised and would want to control the situation. If your significant other continues to make extravagant purchases or decisions without your prior knowledge, you would have trust issues and may want to cut up their credit card while they’re sleeping.
People see banking relationships as far-off and a different type of relationship. But the truth is, it’s all the same. Relationships are relationships. If you or your company or your significant other continues to create negative surprises, it’s not going to help with the relationship.
First, fix the problem before it becomes an issue. As soon as you see a yellow flag, jump on it!
Then after you fix it, let your bank know what has happened and how it has been resolved. This not only comforts the bank but builds trust. If the yellow flag starts turning red, alert the bank and outline the consequences. This helps you prepare and for the bank to prepare. Procrastinating this step can result in devastating consequences. The bank may be able to help you if you give them enough time.
Start identifying and tracking those KPIs that influence your debt covenants. For help and tips on how we measure KPIs, download our KPI Discovery Cheatsheet today! Know your numbers and where your company is the weakest so that you can start turning around your future.

key elements when seeking financing

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Key Elements When Seeking Financing

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Debt to Equity

See Also:
Debt to Equity Ratio
Return on Equity Analysis

Debt to Equity Ratio

The debt to equity ratio is also known as the net gearing ratio. It is a type of leverage ratio that helps show how leveraged a company is. Investors and creditors often use this. The purpose is to see what ratio of equity and debt are used to fund the business. The more debt used increases the debt to equity ratio, thus signifying a highly leveraged business. Lenders see highly leveraged organizations as risky. Because if there are other debt obligations, the company is less likely to repay the lender. Investors understand highly geared (highly leveraged) companies to be more vulnerable to a slow in sales. If sales decrease, the debt service payments could be too high to pay off.

A highly leveraged company can be a riskier investment, because it will always have to service its debt. A low leveraged business uses more of the owner’s or business’s investment than outside investment. This avoids high debt payments that could halt a company’s cash flow during a downturn in sales. A highly geared business may be riskier, but it will also have more capital to expand and be profitable.


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Debt to Equity Formula

The debt to equity formula or equation is (debt/equity.) Many different sources use their own version of the ratio, but debt/equity is the simplest form. Some people prefer to use long term debt in the numerator in order to get a better idea of the risk of long term debt repayment. Whereas, others think this is a skewed view since it does not take short term debt into consideration. It varies by what types of debt the business has and what the investor is looking for.

Looking at the debt to equity formula does not tell the whole story. When considering businesses in different industries, it is important to decide which formula to use. Some industries are at a greater risk of long term debt or short term debt. When comparing these leverage ratios, it is a good idea to compute the basic debt/equity formula as well.

Industry Average Ratios

The internet, trade associations, and research firms have plentiful information on leverage ratios across different industries. This makes it possible to compare one business’s debt to equity ratio against others of similar size. University libraries usually have numerous subscriptions that give this information. They have comparisons across numerous different ratios, sizes, and industries. Interns from these universities have full access to these databases. Another option to gain access to these databases is by paying for access. It is often expensive and risky whether one service will be able to provide each statistic needed. This is why large corporations and universities subscribe to numerous services for the same information.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

Debt to Equity

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Debt to Equity

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Other People’s Money

Other People’s Money (OPM)

In finance, other people’s money, or OPM, is a slang term that refers to financial leverage. Other people’s money refers to borrowed capital that is used to increase the potential returns as well as the risks of an investment. OPM can be used by individuals or by corporations.

Using other people’s money is considered a double-edged sword – it cuts both ways. If an investment that is levered with other people’s money turns out to be profitable, then the profits are magnified by the effects of the leverage. However, if the levered investment goes sour, then the investor that utilized other people’s money can incur steeper losses.

Capital structure refers to a company’s mix of debt and equity financing. Many factors must be considered when determining the optimal mix of debt and equity financing. Increasing leverage, or the use of other people’s money, up to a certain degree can benefit a company by increasing its tax shield. On the other hand, more leverage can increase the risk of default and the incurrence of bankruptcy or financial distress costs.

Other People’s Money Example

Here is an example that demonstrates the risk-return trade-off of using financial leverage, or other people’s money. Let’s say an investor has $100 and plans to invest it in a security that either gains 20% or losses 20% over the course of the year.

If the investment gains 20%, then the investor ends the year with $120, or a profit of $20. However, if the investment losses 20%, then the investor ends the year with $80, or a loss of $20. In either case, the gains and losses represent a reasonable amount in comparison to the original invested capital.

Now, let’s examine the same investment, but with the investor using other people’s money as financial leverage. Let’s say the investor borrows $400 and, along with his original $100, invests a total of $500 in the same investment. The investment will end the year either up 20% or down 20%.

If the investment gains 20%, then the investor ends the year with $600, or a profit of $100. This represents a 100% increase in the original invested capital. On the other hand, if the investment losses 20%, then the investor ends the year with $400, or a loss of $100. This represents a loss of 100% of the original invested capital.

As you can see, the use of other people’s money, or financial leverage, dramatically increased both the upside gains and the downside losses of the investment.

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

Other People's Money
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Other People's Money

See Also:
Angel Investor
Venture Capital
Line of Credit (Bank Line)
What are the 7 Cs of banking
Working Capital

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Operating Leverage

See Also:
Homemade Leverage
Valuation Methods
Financial Ratios
Operating Profit Margin Ratio
Operating Cycle
What Your Banker Wants You to Know

Operating Leverage Definition

Operating leverage is a measure of the combination of fixed costs and variable costs in a company’s cost structure. A company with high fixed costs and low variable costs has high operating leverage; whereas a company with low fixed costs and high variable costs has low operating leverage.

High and Low Operating Leverage

A company with high operating leverage depends more on sales volume for profitability. The company must generate high sales volume to cover the high fixed costs. In other words, as sales increase, the company becomes more profitable. In a company with a cost structure that has low operating leverage, increasing sales volume will not dramatically improve profitability since variable costs increase proportionately with sales volume.

Contribution Margin and Breakeven Point

This term relates directly to a company’s contribution margin and breakeven point. Contribution margin is essentially a product’s selling price minus its unit-level variable cost. A product with proportionately less variable cost has a higher contribution margin. Hence, a product with a higher contribution margin corresponds with a production process that has high operating leverage – or higher fixed costs in relation to variable costs.

Similarly, a company with a high breakeven point has high operating leverage. The breakeven point refers to the level of sales volume at which per-unit profits fully cover fixed costs of production. In other words, it is the point at which revenues equal costs. Because more fixed costs translate into a higher breakeven point – more sales volume is required to cover the fixed costs – a production process with a high breakeven point utilizes high operating leverage. Of course, when a company with high operating leverage and a high breakeven point reaches sales volumes that exceed the breakeven point, a greater proportion of revenues generating are pure profit.


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Degree of Operating Leverage

The degree of leverage of a company’s cost structure is a ratio that measure’s the sensitivity of profits to changes in sales volume. In other words, this measures the degree to which a change in sales impacts profitability. In a company with high leverage, changes in sales volume magnify changes in profitability. Whereas in a company with low leverage the effects of fluctuations in sales volume impact profitability to a smaller degree. Divide the percentage change in the operating income by the percentage change in sales volume to find the degree of operating leverage. Use the following formula:

Degree of Operating Leverage = % Change in Operating Income ÷ % Change in Sales Volume

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Operating Leverage
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Operating Leverage

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Homemade Leverage

Homemade Leverage Definition

In finance, homemade leverage is a technique individual investors can use to synthetically adjust the leverage of a firm. To replicate the effects of leverage in the firm, the individual investor borrows money at the same borrowing rate as the company. They need to add leverage to their portfolio.

If an investor invests in an unleveraged firm, but would prefer that the firm use leverage, then the investor – as long as he can borrow at the same borrowing costs as the firm – can create the effects of leverage in the firm by adding leverage to his own portfolio. Essentially, the individual investor can invest in an unleveraged firm. But they synthetically replicate the returns of an investment in a leveraged version of that firm by borrowing on his own.

Using Homemade Leverage

However, using homemade leverage to replicate the returns of a levered firm with an investment in an unleveraged firm may not work so precisely. This is especially true when taxes are involved. Furthermore, substituting homemade leverage for corporate leverage in an individual investor’s portfolio will not reflect corporate leverage exactly.

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homemade leverage
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Click here to access your Execution Plan. Not a Lab Member?

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Homemade Leverage

See Also:
What are the 7 Cs of banking
How Important is Personal Credit in Negotiating a Loan
Operating Leverage
Required Rate of Return
Financial Ratios

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