How a CFO Evaluates Profitability using Metrics

In today's lecture, we'll be talking about how a CFO evaluates the profitability of a business using two important profitability metrics, gross margin versus profit margin. So we'll talk about the calculation and the insight that you get from each of these two. And if you understand them really well, you can read the financial health of a company in just minutes. So if you like this topic, let's dive right in. Bill Hanna here, your favorite financial controller. I've been in the accounting and finance game for the last 12, 20 years, worked my way up to a controller position, and most recently took a role as a director of finance at a software company in New York City. So before jumping into today's topic and looking at the example that we have here, I want to talk about the why. Why do we evaluate gross margin and profit margin? The reason is this drives our product strategy. So which product do we make and sell and how much do we sell them for? How much do we spend on producing them and things like that? It also influences hiring. So influencing hiring, less or more is going to be dependent on our profitability. It also influences our business decisions overall. So these are things like which location do we set up the manufacturing and selling at, what kind of marketing spend are we going to have, and things like that. This is all is derived from the profitability metrics that we have here. Okay, so we have here an income statement for the Finco Inc. We have revenue of 500,000 COGS of 200,000, and that result in a gross profit of 300k. Operating expenses are 150,000. And then we have taxes and interest of 50,000 leading to a net income of 100,000. Okay, so let's go ahead and calculate gross margin. So our gross margin here is going to be revenue minus cogs divided by revenue. So revenue minus cogs is right here is gross profit, 300k. So this is 300k divided by our revenue, which is 500k. And that equals to 60%. Now what does that say to us? 60%. That says that for every dollar that we sell in product, we make 60 cents in gross profit before we spend on other things like operating expenses, taxes and interest. Right. This is just 60% that we make right out of the gate after we sell our product, just subtracting our cogs. Okay, so that is for gross margin. Let's go ahead and calculate profit margin. So profit margin formula is net income divided by revenue. So net income that we have here is $100,000. So we have 100k divided by revenue 500k and that equals to 20% which saying that for every dollar that we sell in revenue, we make 20 cents in net profit. That's why we call it profit margin. Sometimes we call it net profit margin or net margin profit margin. Net profit margin, the same thing. All right, so now that we've calculated our profitability metrics, how do we know where we stand as a company? So we have a gross margin of 60%. How do we know if that's good or bad? So you need to benchmark this against other companies in the same. So to give you an example of this, when I was in mid career, I worked as a controller at a food manufacturing company and our gross margin was about 30%. So 30% in food manufacturing is actually a good gross margin. Right. But now that I worked at a software company, the gross margin is somewhere about 80 to 90% typical gross margin for a software company around that rate. Right. So you need to benchmark this and you can ask ChatGPT or another AI tool here, here's my industry, here's my gross margin. Is this typical this low or this high? Right. So you got 60% in this case. What insight do we get from this number? Well, the insight that we get is a product related insight. Meaning is our unit price too low? So maybe if you're selling something for a dollar, it needs to be sold for a dollar and 20 cents in this case. Right. Is your cost to produce too high? Right. All the things that go into producing a unit, the ingredients or material, direct labor and your overhead, all these things that go into producing the product, is this too high? And that's why your margin isn't doing so great. Is your supplier cost too high? So you need to visit the suppliers that you're sourcing your ingredients from and figure out are you paying the optimal price or are there other suppliers where you can engage with that have a better pricing for your ingredients? Okay, so this is the kind of insight that you get from a gross margin calculation with profit margin. This is about the business operation overall. This is not about the product. The product is the gross margin with profit margin. This tells you whether the rest of the business is operating effectively. Right. So these are things like selling and marketing. Are you spending the right amount on selling and marketing? Maybe you spend there is too high and that is affecting your operating expenses and making this number too low as a ratio. So you need to spend some time looking at your selling and marketing cost. You need to be also looking at G and A general administrative costs. These are things like the rent that you pay, some of the salaries, legal costs, finance costs, things like that. This is going to be under your gna, so you need to be spending some time on that. The same can be said for R and D. Maybe you're spending too much in R and D and and that is causing your OPEX to be too high, driving this ratio down. The other thing is going to be depreciation and interest. So depreciation is included in a calculation of profit margin because you're taking net income divided by revenue. So depreciation might be too high. If you are not using the correct useful life for your assets, you might have a too high of a depreciation. So you need to be revisiting that and looking into it with interest. That goes into the calculation as well. If you are paying interest in an outstanding loan, you might want to look at that and maybe refinance and negotiate with the bank if you're spending too much on interest. So these are the things that typically a CFO would analyze and figure out which area of the business is causing this weakness that is leading to a low profit margin. All right, so now that we talked about the calculation and the insights that we get from these metrics, we let's talk about a summary of these things. So for gross margin, the cost that goes into the calculation is cogs cost of goods sold. While with net margin it's going to be all of your costs. So this is going to be your OPEX and depreciation, amortization and interest. With the profitability, with gross margin, we're looking at the product profitability from every unit that we're selling in product, how much are we extracting and profit before we talk about all of the other operating expenses, all only product. Whereas with net margin we're talking about the business profitability, the overall business profitability. With the insight, the insight that we got from gross margin gave us insight into the efficiency of production and pricing. Are we pricing our products at the right price? Are we producing them at an efficient enough price so that we extract the most profit out of it? With net margin, the insight that we get is going to be related to the overall financial performance and management of the business. So understanding these metrics here is going to help you make better business decisions, analyze performance of the business and think like a controller or cfo. If you wanted to get deeper into these concepts, go ahead and check out my CFO program on my website, the Controller Academy. I'll leave a link to that down below. 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