The other day, a client who was in search of additional business financing called me to talk about his prospects. His personal situation had not always been the greatest, but his current credit scores are now nearing excellent. The banks that he had been to were all turning him down, and he was searching 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, one comment came out that I could not ignore. He stated that even with the seasonality of his business (he’s in the event planning industry), and the dry period about to end, his sales were already approaching last year’s totals. That is where his biggest mistake was, and the most likely reasoning behind all of the rejection he received.
Most often, people tend to think of sales as the most significant measure of success for a business. Of course, this theory isn’t without merit, as the sales figure often represents the total amount of revenue flowing into a company, at least from the standpoint of the normal day-to-day operations. There are also some other figures that can make their way into the equation, such as advertising income and commission income being two of the more common, but anything other than income from the direct purpose of the business is considered to be “below the line” income in the financial world and not generally included in the same manner. The biggest reason being (other than the fact that it is not why a company is in business), is that such secondary forms of revenue are not predictable or even manageable. In addition, most people only consider gross sales, which is misleading in itself since it does not take returns/refunds into account. So, getting back to the sales figure representing success, it is just plain wrong!
Whichever method you prefer, gross or net sales, it doesn’t matter since both numbers ignore the cost of sales. Cost of sales is total amount of money spent to get the product into the consumers’ hands. The methods of calculating this number vary, since some companies choose to take all of the factors (cost of labor, machine hours, advertising) but for the sake of simplicity I will use just two costs: purchases and freight. These two figures are prominent in the sense that these are the direct costs involved in getting the final product to market. You absolutely have to pay for the components as well as the means for getting the components to you in order for you to assemble your product (unless you are working with a supplier whom 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 from each dollar of sales taking sales and cost of goods into consideration. This is a figure that is more telling of a company’s positioning than simply looking at sales alone since it takes into account not only the sales, but the costs of those sales when comparing performance over time or to other companies in the same industry. In the case of the client that failed to secure financing, his gross profit percentage was relatively unchanged year-over-year, so that was not the reasoning behind the denials. In actuality, this was a good sign, since in a steadily declining economy, he was able to maintain a relatively level profit percentage when many businesses tend to see theirs drop due to the decreased demand combined with either steady or increasing costs.
That leads to the next omission from the equation, which is operating costs. Operating costs are all of the other regularly occurring costs that arise from normal business operations. These include salaries, rents, insurance, automobile, advertising and promotion, office supplies/equipment, licensing, telephone, electric/gas, etc. These costs are important to consider when gauging the success of a business because they are necessary in the normal operations of any particular business. These operating costs reduce the previously discussed gross profit to give you the business’s operating profit. This represents the amount of profit the company made in any given period of time after all of the necessary expenses and costs of goods are considered. This, too, may be used in calculating a key ratio called the net profit margin, which reveals the amount of profit from each dollar of sales taking into consideration sales, cost of sales, and operating expenses, which is an even more telling sign of a company’s success due to the fact that almost all of the expenses are included. This, in fact, is where my client made his big mistake.
While it is true that his sales and gross profit were in line with the previous year, his operating expenses were out of control. The rent on his warehouse space increased 10%, and his electricity costs also increased due to an across-the-board increase by the utility company. Also, he had expanded his advertising campaign to almost five times the amount of the previous year, and was falling behind on credit card payments and paying significant amounts of interest. This is important to understand because the banks look to see that there is enough profit left over after all of the regular and necessary expenses are covered to ensure that, in the case of a business slump or some other unforeseen occurrence, the company is able to maintain its current payments as well as handle the loan repayments.
And then there’s what is the other income/expenses, which is considered to be “below the line” since neither is part of the normal cycle of business, and include interest income (unless it is derived from the company’s main business purpose), insurance settlements, lawsuit payment/payouts, one-time or extraordinary charges, medical expenses that are not covered by an employee benefits plan, among a host of others. These are generally not regarded as heavily due to their infrequent nature but nonetheless are expenses which alter the company’s bottom line. As you can see, there a many factors that go into running a business, so it is not as simple as looking at the gross sales figures to get an accurate view of how a company is performing. Of course, this was all simplified for the sake of making a point, but the point wasn’t to give an in-depth lecture, but rather to show how oversimplifying things can hide potential problems within a company.