Sales figures alone do not reveal everything
The other day a client looking for additional business financing called me to discuss his prospects. His personal situation hadn’t always been the best, but his current credit scores are now approaching excellent. Every bank he had been at was turning him down and he was looking for answers. After a few minutes of complaining about how he was being scrutinized for past indiscretions regarding his personal credit and his lack of “juice” with the institutions he had been dealing with, a comment came out that he could not ignore. He said that even with the seasonality of his business (he’s in the event planning industry) and the dry spell coming to an end, his sales were already close to last year’s totals. That’s where his biggest mistake was, and the most likely reasoning behind all the rejection he received.
Very often, people tend to think of sales as the most important measure of a company’s success. Of course, this theory is not without merit, since the sales figure often represents the total amount of revenue coming into a company, at least from the point of view of normal day-to-day operations. There are also a few other numbers that can enter the equation, such as advertising revenue and commission income, which are two of the most common, but anything other than income from the direct purpose of the business is considered “below of the line”. income in the financial world and generally not included in the same way. The most important reason (aside from the fact that this is not why a company is in business) is that such secondary forms of income are not predictable or even manageable. Also, most people only look at gross sales, which is misleading in itself, since it doesn’t take returns/refunds into account. So back to the sales figure representing success, it’s just plain wrong!
Whichever method you prefer, gross or net sales, doesn’t matter since both numbers ignore cost of sales. Cost of sales is the total amount of money spent to get the product into the hands of consumers. Methods for calculating this number vary, as some companies choose to take all factors (labor cost, machine hours, advertising), but for simplicity I’ll use just two costs: purchasing and freight. These two figures are prominent in the sense that they are the direct costs involved in bringing the final product to market. It is absolutely necessary that you pay for the components, as well as for the means to get the components to you in order to assemble your product (unless you are working with a supplier who is willing to absorb the freight costs). These figures reduce the original sales amount and give you your company’s gross profit or margin, which can then be calculated into your gross profit (margin) percentage by dividing this gross profit by the gross sales amount.
The gross profit (margin) percentage will tell you how much profit the company made on each dollar of sales, taking into account sales and cost of goods. This is a number that is more revealing of a company’s positioning than just looking at sales, since it takes into account not only sales, but also the costs of those sales when comparing performance over time or against other companies in the same industry. In the case of the client who was unable to secure financing, their gross profit percentage remained relatively unchanged year over year, so that was not the reason behind the denials. This was actually a good sign, as in a steadily declining economy, he was able to maintain a relatively level profit percentage when many companies tend to see theirs fall due to declining demand combined with constant or rising costs.
That leads to the next omission from the equation, which is operating costs. Operating costs are all other regularly occurring costs that arise from normal business operations. These include wages, rent, insurance, automobiles, advertising and promotion, office supplies/equipment, licenses, telephone, electricity/gas, etc. These costs are important to consider when measuring the success of a business because they are necessary in the normal operations of any particular business. These operating costs reduce the gross profit discussed above to give you the operating profit of the business. This represents the amount of profit the company made in a given period of time after considering all necessary expenses and costs of goods. This can also be used to calculate a key ratio called net profit margin, which reveals the amount of profit on each sales dollar taking into account sales, cost of goods sold, and operating expenses, which is an even more telling signal. of the success of a company is due to the fact that almost all expenses are included. This, in fact, is where my client made his big mistake.
While its sales and gross profit were in line with the previous year, its operating expenses were out of control. The rent for your warehouse space increased by 10% and your electricity costs also increased due to a general increase in the utility company. In addition, he had scaled his ad campaign to almost five times the amount of the previous year, and was falling behind on his credit card payments and paying significant amounts of interest. This is important to understand because banks look to have enough profit left over after all regular and necessary expenses are covered to ensure that, in the event of a business downturn or some other unforeseen event, the company can maintain its current payments as well as manage loan repayments.
And then there are other income/expenses, which are considered “below the line” since none are part of the normal business cycle, and include interest income (unless derived from the company’s primary business purpose). , insurance settlements, claims payments/payments, one-time or extraordinary charges, medical expenses that are not covered by an employee benefit plan, among many others. These are generally not considered very significant due to their infrequent nature, but are nonetheless expenses that alter the bottom line of the business. As you can see, there are many factors that go into running a business, so it’s not as simple as looking at gross sales figures to get an accurate picture of how a business is performing. Of course, this was all simplified for the sake of making a point, but the goal was not to give an in-depth lecture, but rather to show how oversimplifying things can hide potential problems within a company.
