Profiting from your business decisions
Here’s the first of a series of blogs devoted to understanding your business numbers better and what you can do to change them.
It is a truism that businesses need to trade profitably in order to be sustainable in the long term. We shall ignore cash for the minute, and for this blog, assume all of your clients pay you on time and you have a sensible supplier and overhead payment policy in place. Yep, some assumption that I know..!
Profitability is measured as both an absolute form, for instance, the figure at the bottom of your income statement after deducting direct costs, expenses, depreciation finance charges and tax for instance from your revenue figures. Another measure of profit, and one that is arguably more useful, is the relative measure – or your margins. There are other relative measures you could use as well as time series measures. We’ll go into these shortly.
Absolute Profit Measures
The absolute profit measure can simply be found in your income statement report (or Profit and Loss report) within all accounting packages such as Xero, MYOB, Sage, and Quickbooks. As you can see below, profit can also be measured in a number of ways; Gross Profit, EBITDA, Net profit pre tax and net profit post tax. Confused ? Let us help un confuse you
So when would you use each of these ways of measuring profit?
Here’s a run down of each and their pros and cons
Absolute Profit Measures
Gross profit gives you a great indication as to your pricing levels, your market effectiveness, or your cost of goods purchasing effectiveness
Gross profits should be pretty steady over time and should be assessed by comparing two or more trading periods.
This is summarised on the right
Possible responses to falling margins:
What can you do if gross profits are falling? This is the first question you can answer through analysis of gross profits. If Gross profits are changing then identify the factors contributing to this first. This will be one of the following
The average unit Price of your goods is falling – through increased competition or new market entrants meaning you are needing to rely on discounting to offset this threat
If this is the case, don’t lose heart! First understand the reason for increased unit discounting. There could be a number of reasons, such as:
Absolute Gross Profit Analysis
You are having to work harder to win and retain your business. If this is the case, you should look to understand the new competitors, assess their value proposition, their after sales offering and reputation, their pricing policy and then assess yours in comparison. Are there any gaps in the competitor’s offering that you can exploit? Can you add non price value to your offering? This could be in the form of a loyalty bonus, or additional warranty or something similar?
Tougher economy and trading conditions
If this is the case, you have a number of options at your disposal:
A) Increase your marketing activity. Create greater awareness of your product or service. This doesn’t have to be costing bucket loads of money either. digital and social platforms are relatively inexpensive mediums.
B) Offer loyalty rewards to your existing clients or other additional value – can you bundle multiple products or services into a single offer for instance?
C) Increase your digital presence to find markets you are currently not servicing. It may be worth assessing your web stats, and conversion rates – can you improve your sales funnel better..?
Average unit price is falling due to reduced output from new sales staff perhaps?
What are your options in this case?
A) Consider additional training with those members of staff that need it
B) Understand the reason for reliance on discounting from these staff members – they are the eyes and ears of your business, let them tell you what problems are faced in the market.
Cost of goods input price increases or decreases
Should your input costs be changing, then discussions with suppliers are a must. Here are some options:
A) Assess alternate suppliers for your direct goods or services
B) Negotiate better terms with your existing suppliers
C) Negotiate greater value added from your suppliers – can they help run joint promotions for you?
Once you have assessed changes to your gross margins, if overall net profits are changing, you should then assess what else is going on in your business and the responses you can make to them
Net Profit (EBITDA)
Of all the net profit measures above, Net Profit (EBITDA) is the one I particularly like – as you can see from the profit graphic above, EBITDA is measured before the effect of Depreciation, Finance, Tax etc, therefore, is a clean and true measure of profits, and one not skewed by your accounting or financing choices
The great thing also about this means of measuring profit, is that if gross margins are remaining steady, then it will measure the effectiveness of your staffing levels and non direct purchasing decisions amongst other things
But what if both gross profits and net profits are reducing? This is a problem, but it’s not simple to see which measure is most at fault through measuring absolute levels of profit.
Example Absolute Profit Analysis
For instance, suppose we see the following numbers (See left):
Given this, what do you concentrate on and how do you fix this problem without spending hours on identifying where the problem lies? A better and quicker way of identifying the underlying problem is to use relative measures of profit. Analysing absolute measures can be pretty arduous though but are still useful. In short, using relative measures means a comparative approach to measuring and identifying underlying issues
In order to overcome this, we could use relative profit measures, which may make comparisons much easier and quicker for us
Relative Profit Measures
As you can see, we can use a percentage approach to compare and contrast. As we see in the diagram, gross profit margin is simply the gross profit attained relative to the revenues generated. Net margins are calculated in a similar way, depending upon the preferred measure of net profit. For our analysis and for the reasons explained, we’ll stick with the EBITDA calculation of net profit.
Relative margins analysis
From the example right, we can see (but maybe not clearly), that all margins are falling but it is difficult to work out why from this. You may get this from your accounting package
Alternatively, it may be a lot smarter to compare these graphically.
Analysing data of another company, we have of course used the Jazoodle platform as this is what it does! It does it very quickly too and calculates your numbers from your Xero data:
Relative margins analysis example
From the example below, here you can see that gross margins are relatively steady over the past 3 periods, but a slight drop in the last period.
You can also see that the gross margin has dropped below the red traffic light limit of 30% and showing a warning to us. Compare this to the previous year which is showing an orange light.
To understand the cause of the reduction in gross margins in this case, we can look deeper at one of the other relative measures. Remember we said that gross margin changes can be either down to cost increases, or discounting. To understand this, we can look at what percentage of sales make up cost of goods
A quick calculation shows that Cost of Goods accounted for
Latest year: COGS/Revenue = 70.11%
Last year: COGS/Revenue = 69.74%
We can therefore conclude that the slight reductions in gross margins are accounted for through a small increase in Cost of Goods, and that they are not reflected fully in being passed onto their clients.
So, now lets look at relative net margins
Here we see that despite gross margins being slightly worse off, net margins are recovering very nicely for this company. It is important to assess comparisons over time so that you can understand context
Looking at the individual traffic lights on the dashboard, we see that whilst margins are recovering, they are pretty lean still!
What factors will affect net profit margins..? We have already said, that using the EBITDA measure of net profit, gets rid of a lot of clutter from our analysis, And therefore we only need to look at our expenses or overheads to understand these
Other noteworthy Relative Profit Measures
Overall, we can see therefore that whilst gross profit has fallen slightly in percentage terms, as a result of small direct costs increases, a greater EBITDA profit effect has been seen in managing general expenses within the business
One other measure of relative profitability that is definitely worthy of understanding is that of Earnings Per Share. Jazoodle makes some assumptions about the number of shares you have issued, but the measure is consistent. Assuming that the number of share son issue is equal to the equity available when pricing a share at $1 or £1 depending upon your base currency
Looking at the earnings per share measure within Jazoodle, we see this company has increased its earnings relative to its equity nicely
As a final note, on this, if EPS is falling, this will be down to one of two things; either:
A) Revenues falling and/or
B) Shares Issued increasing
We’ll leave further analysis of this measure to another blog. So, in summary, analysing both gross and net margins are critical to sustainability in business. Measurement can be done either in absolute terms, or in relative terms. We recommend using the EBITDA method of calculating Net Profit margin and in relative terms
Have fun with profit analysis in your business, it'll be worth it