Which element of your business is growing the fastest?
One measure of risk in a business, is the speed with which a business can adapt to a rapid drop in sales, and the possibility of such a drop.
Central to the problem is that operating or fixed expenses are just that – fixed. In good times when the money is flowing, the tendency is to allow anything fixed to rise, because we can. Those new mobile phone contracts are not easily turned off, and nor are employees which become surplus to requirements.
Gross profit is made up of two constituents – the ability to negotiate input costs of purchases, and the number of sales made. An often unrealised input cost is the early payment discount offered to customers.
We look at the income statements of hundreds of clients in our valuation exercises. Very few of them operate on a net margin above 10% of sales (the net profit divided by the sales). Most of them are around 5%. Some are at 2% or even 1%.
On very tight margins, there is a propensity to give in to cash flow pressures and offer early settlement discounts to customers. Those discounts are usually around 2% of the outstanding (sales value, plus VAT). You see what happens here?
Tight margin businesses give away ALL their profits just so they can continue to exist.
I fear there are many people out there in this position ( me included)…and we don’t believe its really the case! Thanks for highlighting it Mark.