In our last post, we discussed that of the 4 critical items, (Profitability, Asset Quality, Liquidity and Leverage) 3 of them are from the Balance Sheet. The 4th, Profitability is on the Profit and Loss Statement, sometimes called the P&L or the Income Statement.
I have a client that over a five-year period of time grew their gross margin from 30% to 40% and grew revenues from $4 million to almost $10 million. It became a focus to be aware of volume and pricing, the two main things that can drive revenue.
Profitability: Gross profit margin and net profit margin are the two key factors in driving your overall profitability.
Gross profit and gross margin:
- Gross profit margin is revenue after COGS for a company that manufactures or sells products. It’s after COS, cost of sales for a service business. It’s tracked in dollars (gross margin) or as a percentage of revenue (gross margin).
- There are two factors that drive revenue, which in turn drive gross profit, price and volume.
- It’s equally important to know your exact unit cost (labor, materials etc.) for every product or service you sell.
- You can increase your gross margin by lowering COGS or COS, however it doesn’t have as much impact as an increase in price or volume.
- The key metric to track your gross profit is the gross margin percentage (gross profit/revenue).
- Gross margin changes positively or negatively are a function of product mix. Not all products have the same margin. A change in price or volume or a change in COGS or COS will change the gross margin.
The positive changes can be due to an increase in price or volume and costs stay the same or costs are lower. It can also be due to a higher mix of more profitable products sold. To get to the bottom of that, you need reporting that can give you accurate data on these factors.
Net profit and net margin:
- Net profit margin is gross profit after operating expenses to include interest expense, other income and expense and taxes.
- However, most companies elect sub chapter S status where taxes flow through to the individual.
- So, net profit and net margin are more commonly reviewed as profit before taxes or pre tax profit margin.
- Operating expenses are both fixed and variable. The expenses you can’t control are typically fixed, like rent, utilities, insurance etc.. It’s in your best interest to keep fixed expenses as low as possible. Variable expenses you can control and can increase in growing months or decrease in slow months (advertising or marketing expenses are an example).
- The key metric to track is the pre tax profit margin (pre tax profit/revenue).
- If you’re adding expenses at a greater rate than you’re adding gross profit, your pre tax profit and margin would likely decrease.
- However, if you’re able to add gross profit and hold the line or decrease expenses your net profit margin will go up or stay consistent.
Depending on what areas you want to improve on your profit and loss statement, you will implement strategy or process to address those issues. The strategies that will have the most impact on your success will be those to address increases in revenue (price or volume), COGS issues will be next and operating expenses will be next. If you have questions please feel free to ask them by hitting the contact button at the top of the page.
