Looking at inventory (II): figuring operating leverage

Analysts get information from company financials by comparing two or more sets

Even if a company’s financial statements have an almost photographic fidelity to the structure and inner workings of the enterprise they represent, it’s very difficult for the outside observer to understand what is being portrayed from one set of financials alone–unless, of course, the company is in disastrous financial shape.

Instead, the analyst gets his information from comparison of two or more sets of financials, preferably covering relatively short periods of time, with one another.  In many ways, sequential quarters are the best, since there is the smallest lapse of time between the observation points.  For companies with significant seasonality in their product mix, however, comparison of year over year quarters will produce the fewest distortions.

Question #1:  is there leverage?

One of the first and most basic question you should ask yourself about a company you are starting to look at is whether it has either financial or operating leverage.  A company with leverage is one where a change in revenue produces disproportionately large changes in operating income.  Leverage comes in two types:

Financial leverage comes from a company’s capital structure.  The idea is that a company that uses debt to finance expansion will produce higher returns on equity as long as the operating profits produced by expansion are higher than the interest expense on the borrowings.

You can do the calculations yourself, but publications like Value Line have statistical arrays that do the work for you.  Look at the lines for “Return on Capital” and “Return on Equity.”  If the numbers are different, the company has financial leverage.  Hopefully the returns on equity are higher than the returns on capital (debt + equity).  That’s the way it’s supposed to work.

Operating leverage, which comes from the operating structure of the company.  Firms with operating leverage typically have high fixed expenses of maintaining a manufacturing (or service) operation, but low variable costs of making each unit sold.

FIFO companies

For a company that uses FIFO accounting (see the first post in this series), finding out the operating profit on an incremental unit of production is easy.

1.  Take the revenue figure for the more recent of the quarter you’re comparing and subtract from it the revenue for the more distant quarter in time.  That gives you incremental revenue.

2.  Do the same for the two operating income figures.  That gives you incremental income.

3.  Divide incremental income by incremental revenue and you get an incremental margin.

4.  Compare this figure with the operating margin for either of the two comparison quarters.  If the incremental margin is larger than the average margin for the quarters, the firm in question has operating leverage.  And, if so, you know that in forecasting future quarters, incremental revenue will earn the incremental profit margin.  Therefore, even small increases in revenue can produce positive earnings surprises.  Conversely, even small revenue shortfalls can produce earnigs disappointments.

LIFO companies

For a company that uses LIFO, however, the situation isn’t as straightforward.  Under LIFO accounting, every quarter after the first can be a kind of mid-course correction to the estimates the company employed in arriving at first-quarter cost of goods.

I think it’s reasonable to assume that a company uses a consistent estimating methodology from one year to the next.  If the company chose last year to add in a little safety margin for earnings later in the year by making a high initial estimate for cost of goods, then it’s a good bet that they’ll do the same for this year.

Therefore, it’s a pretty safe assumption that we can analyze incremental margins using the first quarters of two consecutive years.  In any event, it’s the best we can do.

On the other hand, we take a real risk if we use second through fourth quarters by themselves in a year on year comparison.  We can’t rule out the possibility that they’re just residuals left from the re-estimating process.  But we can use (Q1 + Q2) of the current year vs (Q1 + Q2) of last year to do the incremental calculation described in the FIFO section above.  Similarly, we can use Q1 + Q2 + Q3 or the full year as our comparison base.

For the same reason we should hesitate to  use Q2, Q3 or Q4 alone, we also probably shouldn’t use sequential quarters to do the calculation.

For a professional securities analyst, it may make sense to do quarterly year on year or sequential comparisons for a LIFO company anyway.  If you look at enough years, you may find that there’s a consistent pattern to the LIFO adjustments, so you can anticipate with the company is likely to do in the coming quarters.  Even if there isn’t, you may learn enough to make this a topic of conversation with the company’s management.  If someone is willing to take the time to explain how they approach LIFO estimates, you’ll doubtless learn a lot of things from the explanation that you’d never have thought about otherwise.

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