Profits: How Low Can You Go?

If your profits are slipping in comparison with your revenue and assets, look to your financial statements for insight into what is going on and how to boost performance.

Watch for red flags

Theoretically, when you sell more and invest in additional assets, profits should rise proportionately. Unfortunately, that’s now always what happens. Watch for declining ratios, including:

• Gross profit [(revenue – cost of sales) / revenue],
• Net profit margin (net income / revenue), and
• Return on assets (earnings before tax / total assets).

For all three profitability ratios, look at two crucial components: variations between accounting periods and distinction from industry averages.

Identify possible causes

If these ratios are decreasing, finding the cause is vital. If the whole industry is suffering, the downturn probably belongs to an external trend. If a company’s margins are declining, but the industry is generally sound, it’s possible that management has lost its control of costs — or perhaps receivable or vendor fraud is occurring. To get to the root of the problem, examining the main elements of the income statement is extremely useful.

Revenue. If the top line (gross or revenue) has dropped, your overall profit margin will go down, since less revenue remains with which to cover expenses. Study revenue trends of public companies in the same line of business to establish whether the trend is industrywide or company-specific. For other information-gathering, you can observe trade associations, trade publications and related online sources.

Cost of goods sold. This group of costs is a function of labor, raw materials and overhead components. Labor and direct materials ought to be easily managed and controlled. They should also pose a historical representation of a consistent percentage of revenue.

Overhead is mostly fixed and won’t increase substantially unless significant changes in the company have been made, such as changes in depreciation policy, buying new equipment or moving the production facility. Look at those factors to ascertain if overhead is rising or falling and how the ebb and flow pertains to the gross margin (which basically is revenue minus cost of goods sold).

Selling and administrative costs. Analyze if selling and administrative cost items rose considerably. This part of the income statement may also help expose whether a profit margin slide came about from deteriorating conditions or poor management.

Find clues in your financials

Our experts solve financial mysteries; if you need help discerning why your profits are vanishing, please contact us at 949-860-9902 or click here and someone will contact you. Our team can use your financial statements to identify problem areas, compute financial statement ratios and determine the steps necessary to get your performance back on track.