Build the leverage and build your company net worth
When the day arrives that you engage with a third party to potentially acquire your company, they will look at many aspects of your recent historical financial performance. One such performance area they will probe is your company operating leverage.
The acquirer wants to know about your recent and projected revenue growth and what the cost and expense relationship is with this revenue. They want to know if your revenue growth is driving greater efficiencies and economies which would reflect in better gross or net margin. A positive operating leverage is when your margin improves with incremental revenue and a negative leverage is when margin decreases with higher incremental revenue.
Here is an example to illustrate how to determine your financial operating leverage. Let’s look at it through your Gross Margin. Gross Margin operating leverage is your incremental gross margin divided by the incremental revenue:
Q1 Revenue: $10,000,000
Q1 Gross Margin $: $4,000,000
Q1 Gross Margin %: 40%
Q2 Revenue: $11,500,000
Q2 Gross Margin $: $4,200,000
Q2 Gross Margin %: 36.5%
Incremental Revenue Q2 versus Q1: $1,500,000
Incremental Gross Margin Q2 versus Q1: $200,000
Gross Margin on this incremental revenue: 13.3% ($200,000/$1,500,000)
This company owner can factually state that their Q2 revenue and gross margin grew over Q1 in whole dollars. But, an acquirer will question why the incremental revenue of $1,500,000 came with a lower gross margin (13.3%) versus the overall gross margin of the business (40% in Q1 and 36.5% in Q2)?
The acquirer will want to understand what’s causing this to determine if it’s a new trend that will impact their ownership. They will look at the gross margin and net margin calculations (net margin adds your SG&A costs to the formula). If they see your operating leverage as positive, it could build the purchase price they are willing to pay you for your company. But if they believe the operating leverage trend will be negative, it could reduce how much they are willing to pay.
Each month, review your operating leverage at the gross and net margin levels and monitor them for trends. Use time as a friend to strengthen your leverage and be ready to impress and excite a potential acquirer.
