30/09/10

By David Bloom, co-founder and CEO, fd unlimited

Anyone in business knows, I hope, that buying for a £1 and selling for £2 is better than buying for £1.50 and selling for £2 because of the extra margin. But have you ever quantified the impact of this all the way through to the valuation of your company.

I want to demonstrate with a simple example the impact margins can have on the value of your business and the amount of cash you can generate.

ABC Ltd had annual turnover of £5m last year. It sold 5m items for £1 each. Those items cost 30p each or £1.5m in total. The gross margin is therefore 70p per item (£1 sale less 30p cost) or 70%. So on sales of £5m, after paying £1.5m for the items, ABC Ltd generated £3.5m of gross profit.

ABC Ltd had £3m of overhead costs in the year. So its net profit was £500k (£3.5m gross profit less the £3m of overhead). Assume the net profit of £500k converts to profit after tax (PAT) of £400k.

Company valuations are another topic altogether but for the sake of this article, let’s assume ABC Ltd is valued on a multiple of 5x its PAT. This would value the business at 5 x £400k = £2m.

Let’s say you are able to buy the items for 20p instead of 30p. Your supplier has agreed to do this because you are prepared to buy in larger quantities to make it worth their while. You could put your prices up to achieve the same result but let’s stick with cheaper sourcing for now. Let’s also assume all other variables stay the same so we isolate the impact of the cheaper unit purchase price of 20p.

Annual turnover is the same at £5m, made up of 5m items sold for £1 each. Those items now cost 20p each or £1m in total. The gross margin is therefore 80p per item (£1 sale less 20p cost) or 80%. This is a 10% improvement on your gross margin. So on sales of £5m, after paying £1m for the items, ABC Ltd has now generated £4m of gross profit.

Overhead running costs in the year are the same at £3m. So ABC’s revised net profit is £1m (£4m gross profit less the £3m of overhead). Assume the net profit of £1m converts to profit after tax (PAT) of £800k.

Keeping the valuation multiple constant at 5 x PAT now values the business at 5 x £800k = £4m, double the first scenario. Not forgetting an extra £400k in profit generation to.

You can do the same exercise for overhead reduction and sales price increases and if you’re lucky enough to score on all 3, you can transform the business model.

Of course commercial life isn’t as simple as improving your margin and selling out for a fortune but I hope this article demonstrates the power of margins.

If you need to buy more stock to get a better price, you may need to look at funding requirements and storage capacity, another good reason to keep an up-to-date cash flow.

If you would like support in understanding your margins and running ‘what-if’ scenarios on the impact of changes to your numbers — positive and negative — please contact me at dbloom@fdunlimited.com

fd unlimited provides high calibre and cost effective part-time, interim and full-time Finance Directors, Financial Controllers, Finance Managers, Board Advisors and Back-office Services to dynamic companies with aspirations for growth. Our network allows us to match your need with the right resource, in a matter of hours if needed. Find us at nurl=http://www.fdunlimited.com]www.fdunlimited.com[/nurl]