Sales Figures Alone Do Not Reveal Everything

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All synonyms for gross income.

Whatever you like to call it, I’m not a fan of that number.

Sure it’s important to have money coming into your business.

I mean, you can’t really do much if there’s no money flowing in.

But it’s one of those “sexy” misleading figures.

Similar to asking a fitness expert what their 1-rep max is.

Most of them will tell you they don’t worry about that stat.

I’m more concerned with getting stronger over time as opposed to risking injury by attempting a one-rep max.

Martin Dasko, Pro Wrestler & owner of Studenomics

Or winning championships…

A “regular” NBA named Robert Horry won 7 NBA rings while Hall Of Famers Charles Barkley and Patrick Ewing each won 0.

Based on the “sexy” factor, you’d think Horry was better but you’d be very wrong.

Hell, Susan Lucci was nominated 18 times for a Daytime Emmy before finally winning one.

Even with all those losses, she was the highest paid and one of the most famous/ well-respected actresses in soaps.

You need to think beyond the superficial and dig down to the heart of the matter to find out what the real valuable info is.

The other day, a client who was in search of additional business financing called me to talk about his prospects.

His personal situation had not always been the greatest, but his credit scores were now where one would expect to have lenders fighting to give them money.

And since all small business credit is guaranteed personally by the business owner that sounded pretty logical.

The banks that he had been to were all turning him down, and he was searching for answers.

After a few minutes of complaining about how he was being scrutinized for past indiscretions regarding his personal credit, and his lack of “juice” with the financial institutions he had been dealing with, one comment came out that I could not ignore.

He stated that even with the seasonality of his business (he’s in the event planning industry), and the dry period about to end, his sales were already approaching last year’s totals.

That is where his biggest mistake was, and the most likely reasoning behind all of the rejection he received.

Most often, people tend to think of sales as the most significant measure of success for a business.

Of course, this theory isn’t without merit, as the sales figure often represents the total amount of revenue flowing into a company, at least from the standpoint of normal day-to-day operations.

There are also some other figures that can make their way into the equation, such as advertising income and commission income being two of the more common, but anything other than income from the direct purpose of the business is considered to be “below the line” income in the financial world and not generally included in the same manner.

The biggest reason being (other than the fact that it is not why a company is in business), is that such secondary forms of revenue are not predictable or even manageable.

In addition, most people only consider gross sales, which is misleading in itself since it does not take returns/refunds/discounts into account.

So, getting back to the sales figure representing success, it is just plain wrong!

Whichever method you prefer, gross or net sales, it doesn’t matter since both numbers ignore the cost of sales.

Cost of sales is the total amount of money spent to get the product into the consumers’ hands.

The methods of calculating this number vary since some companies choose to take all of the factors (cost of labor, machine hours, advertising) but for the sake of simplicity I will use just two costs: purchases and freight.

These two figures are prominent in the sense that these are the direct costs involved in getting the final product to market.

You absolutely have to pay for the components as well as the means for getting the components to you in order for you to assemble your product (unless you are working with a supplier who is willing to absorb the freight costs).

These figures reduce the amount of the original sale and give you your company’s gross profit or margin, which can then be calculated into your gross profit (margin) percentage by dividing this gross profit by the gross sales amount.

The gross profit (margin) percentage will tell you how much profit the company made from each dollar of sales taking sales and cost of goods into consideration.

This is a figure that is more telling of a company’s positioning than simply looking at sales alone since it takes into account not only the sales, but the costs of those sales when comparing performance over time or to other companies in the same industry.

In the case of the client that failed to secure financing, his gross profit percentage was relatively unchanged year-over-year, so that was not the reasoning behind the denials.

In actuality, this was a good sign, since, in a steadily declining economy, he was able to maintain a relatively level profit percentage when many businesses tend to see theirs drop due to the decreased demand combined with either steady or increasing costs.

That leads to the next omission from the equation, which is operating costs.

Operating costs are all of the other regularly occurring costs that arise from normal business operations.

These include:

  • payroll
  • rents
  • insurance
  • automobile
  • advertising and promotion
  • office supplies/equipment
  • licensing and taxes
  • telephone
  • utility expenses

These costs are important to consider when gauging the success of a business because they are necessary for the normal operations of any particular business.

These operating costs reduce the previously discussed gross profit to give you the business’s operating profit.

This represents the amount of profit the company made in any given period of time after all of the necessary expenses and costs of goods are considered.

This, too, may be used in calculating a key ratio called the net profit margin, which reveals the amount of profit from each dollar of sales taking into consideration sales, cost of sales, and operating expenses, which is an even more telling sign of a company’s success due to the fact that almost all of the expenses are included.

This, in fact, is where my client made his big mistake.

While it is true that his sales and gross profit were in line with the previous year, his operating expenses were out of control.

The rent on his warehouse space increased 10%, and his electric bill also increased due to an across-the-board increase by the utility company.

Also, he had expanded his advertising campaign to almost five times the amount of the previous year and was falling behind on credit card payments and paying significant amounts of interest.

This is important to understand because the banks look to see that there is enough profit left over after all of the regular and necessary expenses are covered to ensure that, in the case of a business slump or some other unforeseen occurrence, the company is able to maintain its current payments as well as handle the loan repayments.

And then there’s what the other income/expenses are, which is considered to be “below the line” since neither is part of the normal cycle of business and includes interest income (unless it is derived from the company’s main business purpose), insurance settlements, lawsuit payment/payouts, one-time or extraordinary charges, medical expenses that are not covered by an employee benefits plan, among a host of others.

These are generally not regarded as heavily due to their infrequent nature but nonetheless are expenses that alter the company’s bottom line.

As you can see, there a many factors that go into running a business, so it is not as simple as looking at the gross sales figures to get an accurate view of how a company is performing.

Of course, this was all simplified for the sake of making a point, but the point wasn’t to give an in-depth lecture, but rather to show how oversimplifying things can hide potential problems within a company.

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  1. Wait, wait, wait, you mean to tell me that Walmart’s $400B+ in revenues don’t go straight to equity?  Ah, man!  

    You’re right though, sales does have some importance, but it’s not at all a go-to number for a measure of success.  Combine the ratio of sales of one period to another PLUS a net profit margin ratio for each period and now we’re talking! 😀

    1. I was just as surprised as you when I found that out.

      Throw in the operating/non-operating expenses and you get what I like. What really is fun is when you get into book and tax profits and trying to explain to people how there can be 2 different income numbers for the same company in the same period.

  2. I used to work for a Fortune 100 company and we used to do all kinds of interesting accrual entries to massage the sales and cost of sales accounts monthly.  The forecast numbers drive the organization and if you don’t meet the numbers you will be looking for a job.  Some companies are no longer giving guidance forecasts to Wall Street as it forces management to focus on short-term goals which are not always in the best interest of stockholders.

    Nice article Eric!

    1. Thanks, Paul! If you remember, that was also a very big issue on Wall St. as well, as the members of upper management would shift income and expense numbers between periods and divisions in order to seem like the company was doing really well, thereby artificially inflating the stock prices (and their portfolios in the process).

  3. Whoa. I think it’s not just an oversimplification on the owners part, but a real lack of knowledge for how finance works. I’m glad he sought out some professional advice.

    I’d love to know what his balance sheet looked like. When I’m evaluating companies for credit, I usually start with cash flow and liquidity. If he was falling behind in credit payments, I can’t imagine his cash position was looking too good.

    You can earn all the sales in the world, but if you don’t have cash to pay your creditors, you can hardly expect that someone will give you a loan.

    1. Thanks for the input Shaun!

      I agree with you to a degree, but it is the business owners’ duty to educate themselves on the basics of financial reports and the corresponding meanings. If not, then they need to have an accountant behind them who can set them on the right path when they are looking to assess the business’s situation.

      The balance sheet was always pretty good, and he was never in any kind of debt when it came to creditors and suppliers. He was, however one of the people I was talking about in my sales and payroll tax post, which was probably why he was able to pay his suppliers. That also led him into trouble with the IRS and Department of Revenue in his home state since he was taking other people’s money to use for operating expenses.

      This information is also very important when it comes to investing as well. One can’t simply look at superficial numbers such as sales or profit margin alone. Like you mentioned, they need to know about the underlying figures and rations to make informed and knowledgeable decisions.

  4. It sure seemed like the owner missed a few things here.  He could sell a lot of units or whatever and still be running in the negative because his operating costs are too high!

    1. Exactly Jeff. The important numbers aren’t what are readily seen on the surface, but rather they are the underlying figures that no one likes to look at.

    1. He did learn one thing: after sitting down with me he started calling around restructuring the terms from his suppliers to get his costs lower.

      I would suspect that a good number of companies have items on their books that are pushing the boundaries a bit. Small business owners who run their cell phone and car expenses through the business even though they may only use them just as much for personal reasons are the number one thing I find. Of course, I apportion a reasonable percentage back to them personally.