Margins & Profitability

ROS

Return on Sales (Profit/Sales) answers the question, “How much of every sales dollar did we keep as profit?”

Between 0% and 4%, while the company is at least making a profit, it is not bringing in sufficient new equity to fund growth. The industry is growing at about 15% per year. The industry consumes about 15% more capacity each year, which arrives in the form of plant expansions and new products.

Therefore, as the simulation begins, an average company would add about $12 million in new plant each year. If half that or $6 million was funded with bonds, an average company would need about $6 million in new equity. Therefore, if the company does not have the profits, it must either issue $6 million in new stock, or $12 million in bonds, or not grow to keep up with demand. Worse, if it has no profits, its stock price falls, making it difficult to raise equity through stock issues.

This ignores investments in automation, which also require a funding mix of equity and debt.

In the opening round of Capstone® companies have an excess of assets, and that can convert idle assets into productive ones. Therefore, do not worry too much if the company’s profits are low. But after year 3, expect that idle asset cushion to be gone. Profits become critical because those companies with profits can grow, and those without cannot.

What if profits are negative? The company is destroying equity. Its stock price has plummeted, making it more difficult to raise equity. All of the problems described above are now accelerated. In short, trouble.

How can companies improve ROS? Here are a few questions to pose.

1. Can you raise prices?
2. Can you reduce your labor costs? Your material costs?
3. Can you forecast sales better and thereby reduce your inventory carrying expenses?
4. Have you pushed your promotion or sales budgets into diminishing returns?
5. Can you sell idle plant to reduce depreciation? Alternatively, can you convert idle plant into some other productive asset, like automation or new products?
6. Is your leverage too high, resulting in high interest expenses. (See leverage.)

EPS (Earnings Per Share)

EPS (profits/shares outstanding) answers the question, “What profits did each share earn?” EPS is a driver of stock price, and stock issues are an important source of growth capital.

In the table, “Round #” refers to the year in the Capstone®. Round 1 is year 1, round 2 is year 2. The market is growing, and so should profits. In Round 5, for example, an excellent EPS would be ($2 + $5) = $7.00 per share, and a satisfactory EPS would be at least 1/3 that or $2.33.

EPS is important for three reasons. First, profits bring new equity into the company. Second, EPS drives stock price, and the company can issue shares to bring in new equity. Third, any new equity can be leveraged with new debt.

An example may help. Suppose the company wants to invest $15 million in new plant and equipment each year for the next three years. If its profits are zero and it issues no stock, the purchases would need to be funded entirely with bonds. But this would drive up interest expense, and worse, eventually the company would reach a ceiling where bond holders would give it no additional debt. The company would stop growing.

In the end, a company’s growth is built upon equity. If it has equity, it can get debt, too.

How can companies improve EPS? Improve sales volume while maintaining margins. EPS is closely linked with the Asset Utilization and Competitive Advantage categories.

Contribution Margin

Contribution margin is what is left over after variable costs. Variable costs include the cost of goods (material and labor) and inventory carrying expense.

The biggest expense is the cost of goods. If the contribution margin is 30%, then out of every sales dollar, $0.70 paid for inventory and $0.30 is available for everything else, including profits.

Fixed costs are those expenses that will be paid regardless of sales. They include promotion, sales budget, R&D, admin, and interest expenses.

As the contribution margin falls below 30%, it becomes increasingly difficult to cover fixed costs.

How can a company improve its contribution margin? Guard price and attack material and labor expenses.

Change in Stock Price

The change in stock price from one year to the next is an indicator for the long term growth potential of the company.

If the stock price is increasing, the company will enjoy easier access to new equity via profits and stock issues, which in turn can be leveraged with additional bonds, and the combined capital can fund plant improvements and new products.

If the stock price is falling, it becomes increasingly difficult to obtain new investment capital, either equity or debt. Eventually the company’s ability to make improvements comes to a halt.