Profit Terminology

[elohel]

A franchise I'm looking at emulating is claiming these figures:

Average gross sales of $860,000 and an average gross profit of $530,000

So, what do these number really mean?

Gross sales - they sell, on average, $860,000 worth of merchandise each year

Gross profit - is the $530,000 just how much they make after deducting the cost of the merchandise? If so, I feel like that's extremely misleading as that's nowhere near profit once you factor in rent expenses, salaries, etc.

To figure out how much I could expect to earn each year, would I have to take the $530,000, then deduct the tax on that, followed by each expense (rent, salary, etc) to get a final number?


Thanks for any clarification,

Jeremy

[Steve B]

That's how I would interpret it.

[ArcSine]

Agreed. "Gross profit", without any explanatory qualifications, most always refers to the "revenue less merchandise cost" concept you've assumed (or equivalently, "profit before deducting operating expenses").

Still, it's an oft-quoted number when a biz is on the block, because many buyers view the operating expenses as being somewhat malleable, in the sense that they figure that once they're at the helm they'll be making changes to the expense structure (boost advertising, increase productivity, technology-for-labor replacements, etc.).

So while knowledge of the existing expense profile is important, buyers frequently just want to first obtain the gross profit reading on a target biz, to get a back-of-the-cocktail-napkin estimate of "what my bottom line would be, after I've plugged in my own expense assumptions". They can ferret out the operating expenses later, in the due diligence process, if they choose to pursue the deal.

Also, buyers correctly assume that the operating expenses are somewhat subject to manipulations by the seller, in order to put lipstick on the biz just before the sale. Slash marketing costs, put off necessary repairs,....

Merchandise cost, on the other hand, is less subject to such manipulations. It is what it is, as determined by the vendors. So buyers see the gross profit figure as being more reliable, the net income (after expenses) less so. Hence the GP number is popular with buyers.

[elohel]

Awesome explanation, thank you.

I might as well just ask this rather than starting a new thread. I wrote an email to a shop owner, and he told me that his revenue is approximately $600,000/year with a cash flow of $64,000.

Can someone tell me what the heck cash flow is? I googled it, but I still just don't understand what it means to have a cash flow of $64,000.

Thanks again

[ArcSine]

Guy willing to divulge his revenue and cash flow numbers in an email without a nondisclosure ag't first? Now there's a motivated seller :)

Like every other defined term, "cash flow" has definition variants for specific purposes, but garden-variety cash flow is the difference between a company's cash receipts and its cash expenditures. It's analogous to accounting's "net income", but differs where some "net income" items are not considered in "cash flow", and vice-versa.

Depreciation expense, for example, is deducted in arriving at net income, but nevertheless isn't a cash expenditure (biz owner doesn't write a check every month made payable to "Depreciation").

The other side of that coin is the purchase of that depreciable asset. When the owner cuts a check for the new fork lift, that's a cash expenditure (and hence a component of "cash flow" for that year), but the accountant doesn't book that entire check to the P&L as an expense. Instead he sprinkles it across the PnLs of the next 7 years or so, and calls it depreciation.

Thus the fork lift shows up as a deduction for cash flow in the year of purchase, in its entirety (commonly in a category called capex---shorthand for 'capital expenditures'), and shows up in net income in the guise of 'depreciation expense', over the course of its depreciable life.

Many of the diffs between net income and cash flow are diffs of timing only, as with the fork lift. When the biz sells merchandise on credit to a customer in mid-April, the accountant includes the sale on April's PnL, but the cash flow analyst picks it up as a cash inflow item in May when the customer gets around to paying the invoice. Ditto for the purchase of inventory: a cash flow report shows it as a cash outflow when the vendor is paid; the company's income statement shows the inventory as an expense (COGS) when the goods are sold.

Roughly speaking, think of the company's check book. Add up the deposits, deduct the checks, and the difference (hopefully positive, at least on average over time) is net cash flow.

Each metric---cash flow and net income---tells you things about the biz that the other doesn't, and so should be viewed as complements.

That's way too brief to do the topic justice, but it gives the general idea.

[jadzigian]

From a banking perspective, cash flow is defined as EBITDA, Earnings before Interest Expense, Tax Expense (C-Corp), Depreciation Expense, and Amortization Expense. When purchasing a business, I could care less how much in sales the organization generates. The items I would ask for are: What are the 5-year trends in gross margin (Gross Profit/Revenues), Operating Margins (Operating Expense/Revenues), and Net Margin (Net Income/Revenues). The margin numbers tell me how much of $1 in sales is going into my pocket. Net Margin, for example, measures how much of the $1 in revenue is available to be reinvested back into the business or available to the shareholder(s)/members. A net margin of 15% would indicate that $0.15 is available on each $1 generated in revenues.

Gross Margin is important as well because it generally represents the direct variable costs associated with the products you are selling (i.e. hourly wages, inventory costs, etc..) and must be equal or less than your operating (i.e. fixed overhead) in order for any business to remain profitable.

Good Luck!

[Jeff L]

A better way to look at this is:
Sales - $860,000
Gross Profit - 530,000

Cost of Goods Sold $330,000

$330,000 is 38.38% of Sales and may not leave a lot of room for Wage & Expense coverage. To make a 10% return you are left with only 25.81% of Sales ($220,000) to cover Expenses and 25.81% of Sales ($220,000) to cover Payroll.

If that works for you great, but make sure you run the numbers before committing.
Hope this is helpful.
Jeff L

[phanio]

The first figure is your marginal profit - meaning profit after variable costs. The other is a net income after all costs including fixed costs.

If you are a business and you don't sell any product or services, you are still straddled with fixed costs. Each business has their on fixed cost.

Thus, if your business sells $600K and it cost $300K to get those revenues (i.e. inventory, direct labor costs, etc). You then have a 50% gross margin or $300K to cover your fixed costs like rent, salaries, marketing, etc.

Now, let's say you live on the east coast and your rent and salaries are much higher than mine. Thus, you would expense more out of that $300K gross margin then I would.

That is why most people will only talk about gross margins. This is a good business lessen. If you can get that same gross margin but manage your business to reduce its fixed costs then you create a competitive advantage over your competition.

The best thing for you to do is accept that gross margin number - then start researching your local costs for rent, salary, marketing, etc to determine your net profits.

Even in franchising - each business unit will show a different net income becuase each has a differnet set of fixed costs depending on where they are located and how they manage their business.

One example that you bring up is taxes. Your business or franchise may owe 10% in taxes and mine might owe nothing due to the fact that I have one-time charges or lots of depreciation. Thus, after the gross margin, our businesses are completely different.

Lastly, take those revenue numbers with a grain of salt. Not that they may be lying to you but, it could have taken that company years to work up to that number. Ask that company or business owner what they made in their 1st year or second year. I bet it was no where near $600K.