Definition
The term revenue margin of safety refers to a calculation the investor-analyst can use to determine how much revenues can decline before the break-even point is reached. The revenue margin of safety is important to understand when a company has relatively few, but large, customers.
Calculation
Revenue Margin of Safety = (Revenues - Revenue Break-Even Point) / Revenues
Where:
The revenue break-even point is equal to operating expenses divided by gross margin.
Explanation
Also known as the sales margin of safety, the revenue margin of safety tells the investor-analyst if a company will experience financial distress if they lose a large contract with a customer. The calculation is used to determine how far revenues can fall before the company reaches its revenue break-even point, which is the level of revenues necessary to remain profitable.
The investor-analyst can compare the revenue margin of safety value to the revenues provided by the company's largest customers. Some companies depend on relatively few, but large, contracts with customers. For example, a company in the semiconductor industry might supply personal computer or smart phone manufactures with chips used in their devices. The loss of one of these large accounts might be the difference between profitability and a loss in such a capital intensive industry.
Example
Company A's current revenues are $9.000 million, with operating expenses of $2.638 million and a 35% gross margin. The table below shows the company's break-even point.
| Break-Even Analysis (000s) | |
| Current Revenues | $9,000 |
| Operating Expenses | $2,638 |
| Gross Margin | 35% |
| Break Even Point | $7,537 |
| Maximum Profit Potential | $512 |
Note: The maximum profit potential is derived by subtracting the break-even point from current revenues and dividing that value by the gross margin percentage.
Based on the above information, Company A's revenue margin of safety would be (values in millions):
= ($9.000 - $7.537) / $9.000 = $1.463 / $9.000, or 16.3%
This means if Company A were to lose 16.3% of its revenue, then it would reach its break-even point. This can be proven as shown below.
= $9.000 x 16.3% = $1.436
If we lower Company A's revenues by $1.436 million, the break even table would be as follows:
| Current Revenues | $7,537 |
| Operating Expenses | $2,638 |
| Gross Margin | 35% |
| Break Even Point | $7,537 |
| Maximum Profit Potential | $0 |
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