Maximizing shareholder value: how high margins may be deceiving you!

The Importance of accuracy in margin calculations

I am in the business of increasing shareholder value. As value creation is easily measurable by tracking the company valuation, there is no time for hollow concepts. When I am working on a new project, I am always looking for the top value creator items. The business margin is almost always one of them. But why?

Calculating accurate margins is not just an exercise in mathematics; done right, it can tell a powerful business story.

Many shareholders commonly link higher margin levels to superior management. However, I'm here to demonstrate the misconceptions in that belief. Exploring further, I will illustrate how conventional reporting generally promotes quick-fix responses that don't adequately address your fundamental business issues.

Why your financial statements fail

Financial statements provide the bedrock for shareholder value creation. Yet, they are often missing out on the enormous potential they can offer.

But why is that? A large part of this stems from the fact that financial statements generally adopt a compliance- or tax-driven structure. This makes it difficult for them to serve as effective indicators for value creation. Furthermore, many accountants of smaller businesses tend not to be performance-focused, which leads them to be content with this basic structure.

If this still worked in the past, today that approach has lost its efficacy. Businesses are giving their all, yet it seems like they're running out of solutions.

I've noticed firms hitting roadblocks and facing challenges today as their usual reporting formats are no longer adequate.

This is because external ecosystems have changed dramatically over the last years: increased global competition, volatility in demand, high inflation, and new technologies impacting your customer's journey. Add to this the recent increased cost of capital which puts an end to decades of access to almost free cash and you end up in a perfect business storm.

This entails that you need to become more proficient in every facet of your business. And to do this, you need better but also more frequent information!

A deeper look into Financial Statements

Financial statements offer the skeletal structure of a company's financial health. At a glance, one may derive crucial information about sales revenue, operational costs and overall business profitability. However, the true value lies beneath this surface.

An area where time and again I see flaws is in the way companies monitor their margins.

Let's walk through this using a real-life situation many of you will recognize.

In Belgium, an automatic indexation system links wages to inflation. For a long period, this didn't pose too many issues for businesses. However, the recent energy crisis has led to a sudden surge in salaries - with increases hitting bountiful double digits over the past two years. Under these circumstances, inadequate margin calculations can have serious repercussions for businesses.

We'll delve into this further by examining some specific figures from the manufacturing industry:

• The Tax-based P&L shows a steep increase in costs and would call for immediate cost reduction action.

• The Performance-based P&L shows a more nuanced picture: a considerable reduction in margin combined with an increase in costs.

Note this is a simplified example. What would happen when we bring more variables into play? Right, chances are that crucial signals get buried under the same pile, calling for ..... over-simplified action.

The tendency for organizations to resort to cost-cutting measures (Tax-based P&L) significantly differs from tactically balancing cost efficiency and price considerations (Performance-based P&L). Regrettably, the former approach is often the chosen path, largely due to its straightforward execution, the absence of the need for coordinated action and …. inadequate financial statements. Though this strategy might instantly favor your future cash flow, it doesn't promise long-term success. Only the right indicators pave the way for better strategic actions, enduring success, and consequently, enhanced shareholder value: Right format = right signals = right mix of action.

So what can you do to make it right in these challenging times?

Here are some recommendations:

• Apply only 'One version of the truth': ensure that all your reports whether sales, margin, projects, product cost or operations eventually tie into your financial statements. This is the only way to ensure that initiatives in various areas will result in the desired and measurable impact on the company's performance.

• Understand what is critical in your type of business: a rental business, a tech business, a project business, services or manufacturing business are fundamentally different. They will therefore require a different representation in your financial statements which is typically more than only the creation of industry-specific accounts. The Sales, margin and cost structure needs to reflect what is critical.

Let's look at this with an example - A rental business with a strong focus on fixed assets, such as real estate or machinery. One aspect that contributes to your margin would be the depreciation of these assets. This makes the correct calculation and mapping of depreciation a key factor in correct margin representation.

• Driver identification: Drivers refer to the elements that exert the greatest influence on your business operations. A small change in percentage can significantly impact your profit margin. Say, for example, you run an enterprise that heavily relies on energy. In this case, the expenditure on energy would decidedly require separate consideration, rather than being bundled up with miscellaneous costs. When assessing margins, you would generally delve into factors such as Direct Labour, Direct Materials, Manufacturing Overheads, Freight and Shipping Costs of Products, Production Supplies, Depreciation, and Quality Control costs. Once you've thoroughly identified the key drivers of your business, the next step is to develop a system for more granular and precise tracking of these costs. It's not enough to simply lump them together under a general 'cost-of-goods sold' category; each driver deserves its own line on your financial ledger. This will not only improve your margin analysis but also give you valuable insights into the critical areas where improvements could be made, leading to higher margins and increased shareholder value.

• A good practice is also to split the margin in a Variable Contribution Portion and a Gross Margin Portion. Product lines or services showing negative Variable Contributions are red flags for immediate action. The variable contribution portion, typically calculated by subtracting variable costs from sales, provides insight into a line's direct profitability. Those with negative contributions are often a signal that revision or elimination may be needed. The gross margin portion, meanwhile, includes both variable and fixed production costs. This paints a broader picture of profitability, considering both immediate and longer-term operational expenses. When a product or service is consistently failing to cover its variable costs, there's a serious issue that needs prompt attention. This could mean the product pricing is incorrect, or the variable costs are too high and must be reduced. Having these two separate calculations offers more nuanced insights into your business performance, and provides specific areas on which to focus, for instance in reducing costs, adjusting pricing, or potentially ceasing an unprofitable product line or service.

• Allocate the outbound freight costs separately. I often call this the Outbound freight Margin. When we talk about 'freight margin', it relates to the cost associated with transporting your goods or services to the customer's doorstep. Neglecting this factor could lead to underestimations, affecting the overall accuracy of your margin calculation. In fact, by optimising freight costs and verifying if these have been billed correctly, you can potentially unlock additional shareholder value.

Gain more by shedding light on overlooked margins!

There isn't a one-size-fits-all solution for businesses, but by following the previously mentioned steps, you should stand a better chance at forming well-rounded financial statements that ultimately enhance shareholder value.

In this quest for creating shareholder value, every cent counts. And by putting a magnifying glass on your margin analysis you'll be able to better identify, control, and ultimately minimize costs that chip away at your margins.

Once you have a good understanding of your margin, the way is paved for strategic planning. You can then exploit the areas with high-margin potential and resist those with less. This approach will not only increase your accuracy in margin calculation, but also it will bolster your confidence in making executive decisions, hence amplifying the chances of creating an effective shareholder value.

Wrapping up

As you can see, creating and maintaining shareholder value isn't just about the top-line numbers. It's the smaller, often overlooked specifics that can have the biggest impact on your bottom line. So, take the time to hone your understanding of margin calculation and don't be afraid to dig deep. Your shareholders will thank you for it.

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