What’s In Your Margin? Part 3

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Our parents and teachers told us not to compare ourselves to others. While comparisons can be negative, as a measurement tool to assess and improve financial performance, they’re invaluable.  Financial statements tell a story in numbers rather than in words and comparisons are vital to telling that story.  It’s reading time, numbers style.

In last week’s post, I mentioned the importance of viewing income statements not just in dollars but also in percentages of sales.  But to take our analytical skills to the next level, we need comparisons.  Here are some useful comparisons when it comes to the P&L:

Comparing across different periods to identify trends:

  • Current year vs. prior year (a/k/a YOY – year over year)
  • Current month vs. prior month
  • Current year to date (YTD) vs. prior year to date
  • Trailing twelve months (TTM) vs. prior year

Comparing our numbers to competition:

  • Us vs. competition

Here’s a YOY comparison of an income statement in dollars and percentage of sales.  The YOY change in dollars and change in each line as a % of sales is in yellow.  The YOY change in dollars; i.e., (Current Year – Prior Year) / Prior Year) is in green.  Below this table is a step-by-step breakdown of the story as it unfolds.

The story begins here, with Sales.

Sales increased $8M over 2011 sales, a very impressive 67% growth rate (8M/12M).

Cost of Sales represented 60% of Sales in 2012 versus 55% in 2011.  As a result, Gross Margin declined by 5 percentage points, from 45% to 40%.  That 5% on $20M of sales would have generated $1M in additional gross profit and net profit. It’s not a good sign when expenses such as Cost of Sales are advancing at a faster rate than Sales.  In this case, Cost of Sales grew 82% while Sales grew 67%.

We’re approaching the middle of the story now and you can tell it’s not going to have a great ending.  Even the attainment of great operating efficiencies and containment of overhead expenses is not likely to overcome such a big drop in Gross Margin, because individual expenses like rent, sales commissions, office salaries and such pale in comparison to the size of cost of sales.

Operating Expenses (Overhead) increased $2.6M in total overall dollars (which was necessary to operate a growing company) but decreased as a percentage of sales from 40% to 37%, which is good as it indicates that overhead is growing at a slower rate than Sales (54% growth in overhead versus 67% in sales).

Operating Income remained the same YOY (not good given the Sales growth) and Operating Margin decreased 2 percentage points, from 5% to 3% (because the same operating income over a bigger Sales number reduces the operating margin).  This is a disappointing development and shows a decline in the management of the business.

Now we’re at the end of the story.  Net income dollars were the same YOY, despite sales increasing 67%.  This means that the company spun their wheels, increasing sales without adding to the bottom line. It took on more overhead and more risk to support its growing sales.  It used working capital and likely borrowed funds or leased more space to accommodate its growth.  But without adequate gross profit to cover the overhead, it was all for naught.

Gross margin is the culprit in this story.  Had gross margin stayed the same as it was in 2011 (meaning an additional 5% of sales), gross profit would have been $1M higher in 2012 and net profit would have risen another $1M to 7% of sales.

Management must analyze gross margin by product (stock-keeping unit (SKU)) to identify which products are dragging the overall gross margin down.  It must also compare YOY changes in the general ledger accounts that are grouped in sales and cost of sales to see which YOY increases in those items exceeded the YOY increase in sales.

None of the above revelations would have been possible were it not for comparing the most recent year’s P&L to the prior year.  Without such trending, the story would be incomplete and the company would be at risk.

What’s the moral of the story? Know your margins.  If you do, your story will likely have a good ending.

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