GROSS margin drives profitability more than any other factor, and pricing is the key factor driving gross margin, so it's critical for a company to have a realistic pricing program in place for maximum profitability.
In “Getting Back to the Good Old Days: Avoiding Mistakes of the Past,” Mackay Research Group president John Mackay said the Profit Planning Group has been conducting an annual survey of distributors for the NTEA since 1982. The core questions that need to be answered by every company: How much profit should we be making? How can we get there?
“We don't want just growth,” Mackay said. “We want profitable growth and to gain control of profit margin. Many of you are in family-owned businesses, and there are two components to profit: there's the owner's salary, and there's an assumption that the owner is earning an adequate salary based on hours worked; and then there's corporate profit. There should be a risk-return relationship.”
He presented financial results for Company A, a company he said was “slightly smaller than the typical distributor.”
It had sales of $5 million in 2008, with $3.18 million in the cost of goods sold for a gross margin of $1.19 million; payroll and fringes of $654,500 and other expenses of $425,500 for total expenses of $1.08 million; and an operating profit of $110,000. It had total assets of $1.6 million (cash of $80,000, accounts receivable of $362,000, inventory of $870,000, other current assets of $48,000, and fixed assets of $240,000).
Gross margin (“how much money we have to pay operating expenses”) for Company A was 23.8% ($1.19 million divided by $5 million in sales), and operating profit was 2.2% ($110,000 divided by $5 million).
“I only have $80,000 in cash,” Mackay said. “If I could free up a little bit of inventory, I could have more cushion when it comes to meeting payroll for working cash flow on a monthly basis.”
Profit drivers
He said that according to the Strategic Profit Model, there are three ways owners can improve profit:
- Profit margin
Profit divided by net sales. “This is probably what most of us are most comfortable talking about. Did we win or lose? There are three things I can do if I want to make three to four pennies per dollar of profit instead of two: raise the price, cut costs, or sell more volume, if I can hold the line on fixed expenses.”
He said that profit margin for the typical NTEA company peaked in 2006 (3.5%), then declined to 2.9% in 2007 and 2.2% in 2008. Meanwhile, it has gone from 8.6% to 5.4% from 2004 to 2008 for the high-profit NTEA distributors, who make up 25% of those who participate in the survey.
- Asset turnover
Sales divided by total assets. “This tells me how many dollars of sales we can drive out of this business without investing more money. (Company A) is generating $3.13 for every one dollar of asset investment. How can I generate more sales or have fewer assets? This comes down to loans to customers and inventory. 75% of my investment is tied up in inventory and accounts receivable. My goal is generating $3.20 or $3.30 for each dollar of asset investment. And asset turnover hasn't changed much for a long time. In ‘82, it was 2.9 times. However, the high-profit company somehow is using assets more productively.
“Return On Assets (ROA) is return based on everything invested in the business. It's 6.9% for this company. It is best looked at versus the cost of capital. If I'm returning an ROA higher than the cost of capital, it's probably worth investing in this business. Right now, the cost of capital is relatively low. As the Fed starts cranking up interest rates, this hurdle will become more of a challenge.”
The average high-profit distributor had an ROA more than four times that of the typical distributor in 2004, and almost three times higher in 2008.
- Financial leverage
How much do owners have invested and how much do people other than the owners have invested?
“It's total assets divided by net worth, or divided by owner equity in the business. For (Company A), its $1.6 million. Owner equity is money the owner started the business with when he took out a second mortgage on a house. It's also retained earnings they left in the business. If you have a choice, rather than leaving those retained earnings in the business, you'd take it out as a bonus. The owner's equity is about $727,000 for the typical NTEA member.
“The financial leverage ratio is 2.2 times. That says that if the owners have a dollar invested, they were able to finance $2.20 in total assets. Outsiders invested $1.20 in this business. Who owns this business? Outsiders. If they don't own it, they at least control it. Use other people's money. That's the American way. The higher this ratio, the more control we give to somebody outside the business. Banks like to see this as a 1-to-1 ratio. At 1.5, bankers start breathing deeply. As it moves to 2.0, they get chest pains.
“As we're moving forward, this ratio is something your banker probably is going to be asking you a lot about. If you're trying to expand a long-term loan or your live credit, they're going to be looking at this ratio. And that trend has gone up in the last five years (from 1.4 in 2005 to 1.7 in 2008 for the typical distributor). We've become more dependent on outside finances.”
Next Page: ROA trend
ROA trend
Mackay said based on the 10-year trend for ROA, one of the biggest differences between the high-profit and typical NTEA companies is that sales per employee are 10% higher for the high-profit company.
“I have lower payroll expenses because employees are more productive,” he said. “It doesn't say I don't pay them as well. In fact, if you cross-reference the compensation survey the NTEA does with the profit survey, they probably pay their employees better. If I pay them better, they might be more productive and I'll be more profitable? Sounds good to me.”
Mackay said price competition was a big issue coming out of the last recession in 2002, and “that is what we want to try to avoid if we possibly can. Expenses have gone up the last three years, and that will be a challenge as we move into a slow-growth sort of decade.”
He said high-profit companies have consistently had expenses that are three to four points lower than typical companies: “That's a place where we need to be diligent.”
He said the break-even point is sales volume where gross margin equals total expenses.
“If there's a price war — which happened coming out of the last recession — I need more revenue to cover that price challenge,” he said. “That's what we want to avoid. We want to keep the gross margin up if we can.”
The Personnel Productivity Ratio (PPR) is the percentage of each gross-margin dollar that must be devoted to payroll: “This is a way to measure the productivity for employees. For this company, 55 cents of each gross-margin dollar goes for employees. It's a ratio that people probably don't look at it. High-profit companies are always seven to eight points lower. That means lower payroll expenses compared to sales. That means there's more left for profit. PPR probably will go up in 2009 and 2010. Most of you did not lay off as many people as in other industries. I've talked to lot of companies that cut back to 32 hours a week.”
Knowing the business plan
Growth Potential Index (GPI) is an estimate of how fast you can grow without running out of cash — and having to borrow money, he said. It's calculated by taking profit after taxes and dividing it by inventory plus accounts receivable minus accounts payable. For Company A, that's 8.4%.
“If I'm going to grow faster than that, I'd better be going to my bank now and telling them what my business plan is, and how I stand up to industry benchmarks, and why they should be loaning me money,” Mackay said.
He said companies want to control payroll without sacrificing employee enthusiasm, and one of the ways to do that is to make sure there's a difference between how fast a company can grow and how much payroll increases.
“Part of the challenge in the past was operating expenses as percent of sales tended to increase — and we wanted to fight against that. They're going to increase, but we want to make sure there is a gap there in terms of sales volume versus payroll increases.”