Understanding Your Finances: Profit Margins

Profit Margins

In my experience most firms collect loads of management information (MI). However, only a few use it to provide insight into what’s happening within their business.

Ask any adviser about their MI and they’ll usually tell you their assets under management, monthly income or annual recurring income figures. While it’s important to know this information, it really only provides a helicopter view of your business’ results; so if you want to fully understand how your business is performing, you’ll need to go deeper. Remember, the aim of doing any financial analysis is to generate insight to enable you to improve future decision making.

As a starting point, there are three critical figures that you must understand in order to improve the performance and profitability of your business:

a) Gross profit margin

b) Overhead percentage

c) Net profit margin

Let’s start by understanding gross profit margin:

Gross profit margin is critical. Without a suitable level of gross profit margin, you have no chance of ending up with any net profit.


Turnover – Direct Expenses = Gross Profit


Direct expenses (sometimes referred to as cost of sales) includes all remuneration paid to advisers and directors that sell to clients, including:

  • Commissions and salary + national insurance
  • Car allowances
  • Bonuses
  • Pension payments
  • Directors’ drawings

Direct expenses would also include any pay-aways to introducers, if you make them.

The money paid to sales people, selling directors and introducers/referrers is taken from your top line revenue first, which means that the business can only pay its other overheads (rent, equipment, wages for other staff, etc.) from the balance remaining.

In many firms, self-employed advisers are paid 50-60% of the gross revenues they bring in, which is both unsustainable and often a contributing factor to poor net profitability.

Ideally, direct expenses should not exceed 40%, leaving you with a minimum gross profit margin of 60%. Remaining overheads should not exceed 35%, which leaves a genuine net profit margin of 25%. This should be your aim.

When you do this analysis for yourself and look at the three critical figures, you will realise that keeping your business overhead to 35% is no mean feat in itself, so if you are not careful, paying away more than 40% of your gross revenues will leave you severely profit-squeezed.


Gross profit ÷ Total revenue = Gross profit margin


For example:

Turnover: £500,000

Less direct expenses: £200,000

Gross profit: £300,000

Gross profit margin: 60% (£300,000 ÷ £500,000)


Pitfalls

It is highly unlikely your accountant or internal bookkeeper prepares your monthly accounts using this formula. Even if they do, what figure do they include for working directors’ remuneration?

In many businesses, owners will take minimum levels of tax-free salary and additional monthly drawings which are accounted for (at year end) as dividends from profit. Whilst this is fine from a tax planning perspective, if you receive regular financial information in this format, you’ll have no clue as to how your business is really performing.

Following on from the example above, let’s assume we have two owner/directors in the firm who each generate £250,000 of annual revenue, but only draw £10,000 each of salary.


The annual accounts now look like this:

Turnover: £500,000

Less direct expenses: £20,000

Gross profit: £480,000

Gross profit margin: 96% (£480,000 ÷ £500,000)


Clearly this isn’t an accurate reflection of what you are really drawing as owner/directors and now your gross profit margin is overstated.

By including a more accurate figure for directors’ remuneration (£100,000 each in the first example) we get a true reflection of this aspect of the business’ performance.

The same trap applies if you take annual remuneration that is less than a genuine market salary.

Let’s say that both directors in our example drew just £60,000 each of salary and dividends per annum. Yet, with £250,000 each of annual revenue they could almost certainly take their client bank down the road to a competitor and receive far higher levels of remuneration (let’s assume £100,000).

A common (and often frustrating) occurrence while a firm is still growing, is for the owners to act as the bank! [click to tweet]

The real problem here is that when the owners take a cut in salary, the profit issue doesn’t look as bad, so the owners convince themselves that everything is fine. That is, if cash flow is tight, they take less than market remuneration, while everyone else that works in their business (back office staff, paraplanners) gets paid their full going rate.

In the example below we will assume that overhead is above the recommended benchmark of 35% (as is usually the case in smaller, growing firms).


Look a how this plays out and creates a misleading impression for the owners:

Turnover: £500,000

Less direct expenses: £120,000

Gross profit: £380,000
(Margin = 76% or £380,000 ÷ £500,000)

Less overheads: £275,000
(Percentage = 55% or £275,000 ÷ £500,000)

Net profit: £105,000

Net profit margin: 21% (£105,000 ÷ £500,000)


The net profit figure appears to be an acceptable 21%, but it’s actually quite misleading. If we substituted the real market salary for both owners (£100,000 each) the net profit figure drops to just 5%.

What’s the harm, you might say? These owners are running a small advisory business and essentially earning £112,500 each (if you split the drawings and profit between the two of them). However, I would argue that:

  • £112,500 is their basic wage for doing the job, which they could just as easily earn working 9am – 5pm down the road with a competitor; which would also eliminate the stress that running a business places on them and their families.
  • With increasing capital adequacy provisions, lack of profitability makes complying a potential headache in the future.
  • Owners of businesses need (and deserve) to be compensated adequately for the risks they are taking.
  • Real businesses make profit, some of which is distributed to shareholders for their capital at risk and some of which is reinvested in the business each year (in better people, technology, marketing etc.) to allow it to continue to grow.

A clear understanding of your gross profit margin is an essential step in increasing the profitability of your business.

By Brett Davidson
Google

Share:

Leave a Reply