Understanding the True Profit Margin

By Joe Ponzio on August 7, 2009  |  32 comments

On the heels of yesterday's article, I received an e-mail from a friend this afternoon asking me about my thoughts on inventory turns and profit margins. To paraphrase: The math doesn't work right, as the inventory turns don't affect the profit margins each year.

I didn't do a good job of explaining it properly; so, let's look at the "true" profit margin of a company.

The Low Cost Business

We all know that it's better to have a low-cost business than a high-cost business. Companies with relatively small capital expenditures and fat profit margins should be chosen over those with high capital expenditures and thin margins, assuming all other things are equal.

If you can find good companies that generate tons of cash on a relatively small amount of invested capital, and you can buy those companies at a discount to their intrinsic value, you'll probably find that your long-term investment results are quite satisfactory.

Profit Margin on One Inventory Turn

So...we turn to two businesses, each of which has a thin profit margin, to see how inventory turns can give us some insight into the economics of the company. Let's first look at the economics of the business from a single sale perspective to show that they're the same:

(Note: The number of "inventory turns" refers to the number of times a company must replenish its inventory throughout the year. If Walgreens orders one case of Coca-Cola each month, and sells one case each month, it will have "turned" its Coca-Cola inventory twelve times that year.)

In this case, both businesses earned $2 on $100 of revenue. Their profit margins were 2% ($2 divided by $100). Fortunately, they lived in the land of Tina's Family Therapy; so, no taxes or any other costs.

Both companies invested $98 in inventory (cost of goods sold), sold it for $100, and made a $2 profit. Simple enough.

Conventional wisdom would say that both businesses should be avoided. We're supposed to look for businesses with wonderful economics, and a 2% profit margin is anything but "wonderful." Then again, we're all about being non-conventional around here.

Profit Margin on Multiple Inventory Turns

Same companies, but factoring one year of inventory turns into the mix:

Right off the bat, these companies may still look similar. Though Company A has greater sales and revenues than Company B, they both boast 2% profit margins and seemingly terrible economics.

Then again, these are businesses, not just numbers on a piece of paper. And the business of Company A is far superior to that of Company B from an owner's perspective.

What Each Business Invested to Earn Their Income

Let's first look at Company B. To generate $4 in income, it invested $196 in inventory (cost of goods sold), right? Wrong. Because it had two inventory turns, it invested $98 in inventory to generate $100 in sales, took the profit from that, reinvested the $98 in more inventory, and then turned another sale.

Essentially, Company B invested the same $98 twice to earn $4. Already see where this is going?

Company A invested $98 in inventory to earn $2, but was able to reinvest that $98 eleven more times to generate a total of $24.

Both companies invested $98 to earn $2, but Company A was able to reinvest it faster, thus generating six times more than Company B.

The "true" profit margin of Company A was not 2%, but 24%. The "true" profit margin of Company B was not 2%, but 4%. Here's how it works:

True Profit Margins...as Bonds

Think of the true profit margin as a bond with a fixed interest rate. Would you rather have a bond paying 24% or a bond paying 4%? The answer is clear.

Company A and Company B both invested $98 into their business through the purchase of inventory. In essence, each purchased a $98 bond (the inventory), and that bond generates a certain amount of profit ($2). Except that Company A's "bond" pays that $2 monthly while Company B's "bond" pays $2 every six months.

Which company has better economics? They both have terrible profit margins from an accounting standpoint, but then again — accounting numbers are for the IRS. Business owners and investors follow the cash.

Which Company Will Grow Faster?

It's pretty clear in the above example that Company A will have a better chance to grow faster than Company B. It generates more in sales, and it generates more cash. Let's level the playing field. Instead of selling products for $100, Company B is selling higher priced goods. It buys products for $588 and sells them for $600. Both companies have the same revenues, cost of goods, net income, and profit margins:

So...which is the better investment?

Though it looks like we've leveled the playing field, we really haven't. These are two very different businesses. To understand this, we have to work backwards.

How will Company A and Company B generate additional cash? With no other expenses, they each have three choices:

• raise the price of their products (e.g., from $100 to $105, from $600 to $630),
• lower their cost of inventory (e.g., find cheaper inventory at, say, $90 and $500), or
• sell more of their products.

If they can't raise prices and they can't find any cheaper suppliers, their only option is to sell more of their product. While that is great in theory, it ain't so simple in the real world. Unless they have some magic formula for making cash appear out of thin air, how will they purchase additional inventory so that they can sell more of their finished product?

Assuming neither has cash in the bank or access to outside financing, they have one of two choices:

• require payment upfront, and then use the customer's money to purchase inventory, or
• save up enough cash to purchase more inventory, using the funds of the business.

Some businesses can do the former; but, let's assume that these two companies are retailers, and that their customers aren't paying for clothes today, but willing to take delivery in sixty days. To get more inventory which will lead to more sales, the company's must use the funds of the business.

But wait — neither company has cash in the bank! Okay — how long will it take before the companies can expand? That is...which company will grow faster?

In 4.1 years, Company A will have saved $98 from its $24 of profits — enough to purchase another unit of inventory. With two units of inventory both being sold concurrently, the company is generating twice as much cash.

It will take Company B 24.5 years to save up $588, if saving just $24 per year. As such, Company B will have to wait 24.5 years before it can double its cash flow.

Again — which company has the better economics: the one that can double every four years or the one that doubles every 25?

The Race is Over Before it Begins

If we fast forward and look at these two companies in 25 years, assuming that each tried to beef up their inventory at the end of the year (not 0.1 years into year 4), Company B has finally purchased another unit of inventory and will begin generating $48 a year in excess cash. Company A, on the other hand, has 465 units of inventory and is generating $11,160 in excess cash.

And while Company B has finally beefed up sales to $2,400 ($600 times 2 inventory turns times 2 units of inventory), Company A is generating $558,000 in sales — 233 times the amount of sales!

High Profit Margin/Low Turnover

Finally, consider this: A high profit margin business may have a very low "true" profit margin, and may be a candidate to avoid. When comparing a 2% profit margin business to a 10% profit margin business, many investors automatically assume that the 10% business is better.

That's not necessarily true.

Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.

I apologize for any confusion I caused in this post.

Also Filed Under "How to Value a Business"

• When growth slows down
• Do The Math In Your Head
• From Free Cash Flow To Earnings And Back
• But Can They Sell It?