Enhancing Financial Analysis: Operating Profitability & Working Capital | CFA Level I

In this segment, we delve into the crucial aspects of analyzing a company’s operating profitability and working capital management. Let’s explore how to dissect a company’s past performance and project its future trajectory.

Operating Profitability: Leverage’s Role

Leverage, or the proportion of fixed costs within a company’s cost structure, plays a pivotal role in determining operating profitability. A higher degree of leverage indicates a greater reliance on fixed costs, such as rent and salaries, which remain constant regardless of production levels. We differentiate between fixed operating expenses and fixed financing costs, with the former including costs like depreciation and the latter comprising interest payments.

Unit Cost = (Fixed Costs + Total Variable Costs) / Number of Units Produced

Understanding economies of scale and scope is crucial here. Economies of scale describe cost advantages realized through increased output, while economies of scope occur when diversifying product lines leads to cost efficiencies.

Understanding Business Risk

Business risk pertains to the variability in operating income (EBIT) due to fluctuations in sales and fixed operating costs. It encompasses both sales risk and operating risk, with the latter directly linked to the degree of leverage a firm employs. Analyzing business risk is essential for gauging a company’s susceptibility to economic cycles and market dynamics.

Business Risk and Its Components

Firstly, business risk refers to the risk associated with a firm’s operating income or EBIT. EBIT can vary significantly, which poses a substantial risk to the company.

Since EBIT is the result of the firm’s sales and the expenditures necessary to produce the sales, these two are the main components of business risk:

• Sales risk is the uncertainty about the firm’s sales.
• Operating risk is the uncertainty in operating income caused by fixed operating costs. As we learned in the last lesson, the greater the degree of leverage, the greater a firm’s operating risk.

Calculating the Degree of Operating Leverage (DOL)

To measure the level of operating risk of a company, we can estimate the degree of operating leverage (DOL) of the company. This measure is the sensitivity of a firm’s EBIT to its sales and is defined by the ratio of the percentage change in operating income to the percentage change in units sold.

For example, a ratio of 3.0 means that for every 1% change in the number of units sold, the operating income changes by 3%. So if the number of units increases by 5%, the operating income should increase by 15%.

To calculate DOL, use this formula:

DOL = (Q * (P – V)) / (Q * (P – V) – F)

Where Q is the quantity of units sold, P is the sale price per unit, V is the variable cost per unit, and F is the fixed operating costs. Note that this should not include any fixed financing cost, as we are only interested in the operating leverage at this stage.

However, you’ll notice that you cannot calculate DOL without knowing the quantity of units sold. The DOL of a firm is not constant and depends on the quantity of units sold or the level of production the company is at. If Noke is selling 1,000 units per month, its DOL will be 1000(10-2) / [(1000(10-2) – 5000] = 2.67.

Degree of Operating Leverage in Different Forms

If we multiply the number of units in the DOL formula, the formula can be expressed in this different form:

DOL = (S – TVC) / (S – TVC – F)

Where S is the sales or revenue and TVC is the total variable costs. Note that in this form, the denominator is operating earnings or EBIT.

Calculating EBIT with DOL

Conclusion: Towards Comprehensive Financial Analysis

Mastering the analysis of operating profitability and working capital is fundamental for evaluating a company’s financial health and strategic positioning. By understanding leverage, business risk, and the mechanics of the cash conversion cycle, analysts can develop a nuanced view of a company’s operational efficiency and market potential.