Operating Leverage

Looking for Margin Expansion & How Companies Cook Books of Accounts:

This section discusses how a company is set up for operating leverage and the key triggers for it, while the following section discusses how companies cook their books of accounts and how an astute investor can spot them without doing too much analysis. 


Operating leverage: When a company increases output, it adds less to its fixed costs, resulting in a more than proportionate increase in profits. Companies with a high gross margin but a low net margin are more likely to see their margins expand. A company that manipulates its financial statements will typically show lower revenues, higher expenses, or a larger block of fixed assets. Because of asset over invoicing, fixed assets are valued at a higher rate. 


Dividends and taxes are good indicators of earnings quality because they must be paid in hard cash. 


Keep an eye out for frequent equity dilutions. The rate of increase in inventory and receivables should not be faster than the rate of increase in revenue. A change in auditor or an excess of related party transactions are also red flags.


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