Back to basics: from sales to profit

The purpose of a for-profit business of any size is to make profit. However, when people say that the company is making money or that an investment has a good return, they often mean different things. And sometimes they don’t even have profit in mind. So, let’s look how a company transforms sales into profit by defining revenues, cost of sales, and operating expenses.

First of all, sales are not sales. There are gross sales, which represent unit sales of products or services at list or gross price. This list price represents the price that a company may publish in its official price list. Most of the time, however, companies offer discounts off these list prices.

Discounts may include negotiated discounts with specific customers, which are then offered anytime to these customers as long as the negotiated contract is in place. Discounts may also include time- or deal-limited price reductions offered as part of a promotion activity. Some companies that use distribution partners to sell their products classify also costs associated with supporting these distribution partners as discounts.

Gross sales minus discounts lead to net sales or net revenues. Net revenues represent the money that the company receives from its customers.

Net revenues = gross sales – discounts = units * list price – discounts

Second, all of the products or services that are sold to customers need to be produced and delivered, which creates cost. This cost of sales (COS) is obvious in a manufacturing environment: all the materials and parts that are needed to assemble the product plus the people assembling it plus the manufacturing facility are all part of COS. In a service business cost of sales may not be obvious, but delivering the service usually requires people providing the service to customers. The cost of these employees represents COS in a service business.

Once all costs of sales are accounted for, they are subtracted from net sales to calculate gross margin or gross profit. Sometimes gross margin percentages, which are gross margins as percentage of net revenues, are used to compare companies in an industry to determine how efficient their operations are.

Gross margin = net revenues – cost of sales

Third, every company incurs costs associated with operating the business. These costs are called operating expenses. Operating expenses are usually divided in engineering expenses or research & development (R&D), marketing and sales expenses, and other expenses. Other expenses can include administrative expenses that are not accounted for anywhere else or allocations from headquarters in large organizations.

When subtracting operating expenses from gross margin we arrive at operating income or operating profit.

Operating income = gross margin – operating expenses

Most companies pay taxes. Taxes are based on the operating income the company achieves and are usually a percentage of the operating income. When subtracting taxes from operating income we get finally to net income or net profit. This net income is at the end the measure that can be used when talking about “making money”.

Net income = operating income – taxes
= units * list price – discounts – cost of sales – operating expenses – taxes

What we have reviewed here is the income statement or profit & loss statement (P&L). This statement is an important document describing the profitability of the company. It is used mostly for accounting and taxation purposes. For investment purposes, however, it is more appropriate to evaluate cash flows, which may differ from the measures described here. But on cash flows and why cash is king at some other time.

(Almost) crystal ball: Monte Carlo simulation

Although net present value (NPV) rocks, it is hard to believe that any financial metric representing the future outcome of an investment correctly describes what will REALLY happen. After all, cash flows that are inputs into the NPV analysis are forecasts and forecasts are never accurate. In lieu of a good crystal ball, you can run some scenario analyses or go straight to Monte Carlo simulation.

Monte Carlo simulation is a sophisticated scenario analysis. It’s a technique where you can model thousands of scenarios in a matter of seconds. Unlike typical scenario or what-if analyses that allow you to analyze the impact of changing one input variable at a time, Monte Carlo simulation analyzes all possible combinations at once. In a typical scenario analysis, you manually calculate as many scenarios as you deem necessary. Monte Carlo simulation, on the other hand, calculates these scenarios automatically, based on your definition of simulation parameters. It allows you to run thousands of scenarios instead of the few in a typical what-if analysis.

Monte Carlo simulation was popularized by physicists in the 1950s at the dawn of the computer age and it got its name from the Monte Carlo Casino in Monaco. Games of chance played at a casino exhibit random behavior that is bound by the characteristics of the game. When rolling a die for example, you know that a number between 1 and 6 will come up, but you don’t know which one.

Similarly, in an investment project you may know the range of possible financial outcomes, but you don’t know exactly which one will materialize. Monte Carlo simulation allows you to model all potential scenarios driven by the uncertain inputs. As a result you will know not just whether an investment will be profitable, but how likely it is to be profitable and how profitable it is likely to be.

Although Monte Carlo simulation will not eliminate uncertainties in business decisions, it can help you to understand them in normal business circumstances. For example, if there is a chance of negative financial outcome in your business, Monte Carlo simulation allows you to assess what might go wrong and helps you to be proactive with the decisions you make. Similarly, if you’re allocating resources among several projects, Monte Carlo simulation helps you to determine which ones have the greatest chance of success.

Monte Carlo simulation can especially be helpful in financial projections for investments that are not based on repeated past experiences. These projections are most often badly flawed. Although Monte Carlo simulation will not help to predict all possible events, it will help to prepare for those events.

Monte Carlo simulation can only go so far, however. It is, like also standard scenario analyses, only accurate for scenarios not wildly different than typical business circumstances. There may be, however, extraordinary, though not absolutely unlikely events that are widely different. Events like these, referred to also as Black Swans, have a low likelihood of occurrence, but big impact. Since Black Swans are unexpected by definition, they are not modeled in financial analyses. But more on Black Swans at some other point in time.

Why NPV rocks

Net present value (NPV) is the most versatile investment metric. It’s based on forecasted cash flows and the opportunity cost of capital. You should accept any investment projects with NPV greater than zero. NPV is an absolute measure, it recognizes the time value of money, and is less prone to interpretation mistakes than its alternatives. Alternative investment criteria such as profitably index, payback period, and the internal rate of return are missing one or more of these characteristics. Let’s examine them.

The profitability index, also known as benefit-cost ratio, is defined as the present value of future cash flows divided by the initial investment. The profitability index rule is to accept any investment project with an index greater than one. Profitability index most closely resembles net present value. When some people refer to return on investment (ROI) as a metric, they basically mean the profitability index, assuming of course that the ROI calculation is done correctly as described in one of the previous posts.

However, the key problem with the profitability index is that it’s a relative metric. A relative metric doesn’t allow to make reliable comparisons of investment alternatives. A ratio doesn’t tell you in absolute terms how profitable an investment is versus all investment options. It only tells you how profitable it is versus its own investment.

The payback period is determined by the number of periods – usually years – it takes until the cumulative cash flow becomes positive. Investment projects are accepted if the payback period meets some predefined cutoff period. Since this rule doesn’t take the time value of money into account, a slightly better version of this metric is the discounted payback period, which is based on cumulative discounted cash flows.

In either case, the payback period is a subjective measure. It is driven by an arbitrary choice of a cutoff period. This metric ignores any cash flows thereafter. Is an investment with a 2-year payback period better than one with a 3-year payback period? Without analyzing cash flows after these 2 or 3 years, i.e., without knowing the absolute profitability, it’s impossible to tell.

The internal rate of return (IRR) is defined as the discount rate at which an investment project would have zero NPV. According to the IRR rule, you should accept any investment project offering an IRR above the opportunity cost of capital. Although IRR is widely used in finance and is based on discounted cash flows, i.e., it takes time value of money into account, it has several drawbacks.

First, the calculation of IRR is iterative. Although most spreadsheets and financial calculators provide an IRR function, you have to start with a guess for the IRR. Spreadsheets or calculators try then to determine the true IRR through several iterations. This wouldn’t be problematic in itself, but this brings us to the second issue.

Second, if the cash flow changes across periods from positive to negative or vice versa more than once, there may be several IRRs or no IRR at all. The wrong initial guess of the IRR for the iterative calculation will lead to the wrong final IRR.

Finally, as with any relative metric, IRR is unreliable in ranking projects of different scale and risk. Is an investment with an IRR of 19% and the opportunity cost of capital of 12% better or worse than an investment with an IRR of 13% and the opportunity cost of capital of 6%? In both cases IRR is 7 percentage points above the opportunity cost of capital. But without knowing the absolute investment returns it’s impossible to tell which investment is financially sounder.

Although there were more shortcomings of IRR discussed here than of the other two metrics, it doesn’t mean that IRR is worse. However, since IRR is widely used but can be easily misinterpreted, we spent more time addressing its drawbacks. By the way, others agree with us regarding the weaknesses of IRR. The CFO Magazine, for example, published a McKinsey article that warns of using IRR and claims that the most straightforward way to avoid problems with IRR is to avoid it altogether.

To summarize, NPV rocks.

A safe dollar is worth more than a risky one

This is the second basic principle of finance. Future cash flows are not certain. However, some are more certain than others. You can be more certain of future values of government securities, for example, than of the future values of the stock market.

Different investments have also different levels of uncertainty or risk. The concept of present value as defined in the previous post can help with risky investments as well. In the present value calculation the future cash flows are discounted by the rate of return offered by comparable investments. The choice of these comparable investments will depend on how risky the investment project is.

Let’s come back to the example from the previous post. Suppose that in the calculation there the investment was comparable with investments in government securities. And suppose we expected government securities to provide a 6 percent rate of return, which led to the choice of this rate in our calculation. The $100 investment today with the $120 payoff a year from now led then to an NPV of $13.

Let’s use now a second example of similar $100 investment and $120 payoff a year from now. But this time let’s assume that the project is as risky as investments in the stock market. And suppose that we forecast a 12 percent rate of return for the stock market.

For this more risky investment the NPV would be $7 as calculated below. This new NPV is $6 lower than calculated previously since the investment project is now riskier than the previous one. The previous safer investment was worth more than the new riskier investment.

NPV formula

Unfortunately, finding the correct rate of return through comparable investment alternatives is more complicated than our two examples suggest. One proven approach is the use of a risk matrix. The risk matrix helps to weigh several risk factors that drive the risk of an investment. Such a risk matrix provides also a consistent approach to determine the rate of return for every investment project throughout the company. Whatever approach you choose, it’s crucial to use the same approach consistently to make apples-to-apples comparisons between safe and risky investments.

Time value of money

“A dollar today is worth more than a dollar tomorrow.” You may have heard this phrase few times before and there is a reason for that: time value of money needs to be considered in every financial analysis that covers more than one time period. This is also the first basic principle of finance. So, it may be useful to explain what this means.

Since it’s usually easier to explain concepts using examples, suppose you can invest $100 today to get $120 a year from now. To make the right investment choice, you would need to know what is today’s value of these future $120 and then compare it with today’s investment of $100. Today’s value of future cash flow is called the present value. The present value in our example must be less than $120 since today you could invest the money to start earning interest immediately.

The present value of a delayed cash flow can be found by multiplying the cash flow by a discount factor. Mathematically speaking, the discount factor is expressed as the reciprocal of 1 plus a rate of return as shown in the formula below. (The formula below would need to be adjusted if there is more than one time period being evaluated, but this is being omitted here for simplicity.)

Discount factor formula

The rate of return r is the reward that investors demand for accepting delayed payments. The rate describes the return offered by comparable investment alternatives. This rate of return is also referred to as the discount rate, hurdle rate, or opportunity cost of capital.

Coming back to our example, we need to discount expected future cash flows to arrive at their present value. Let’s assume for now that comparable investment alternatives yield 6 percent interest. Hence, our rate of return would be 6 percent and the present value of the $120 a year from now would be $113 as shown below.

Present value formula

Now, let’s compare this present value with today’s investment of $100. We can calculate the net present value (NPV) of $13 by subtracting today’s investment from the present value as shown below. Since NPV is positive, it would make financial sense to make this investment, everything else being equal.

NPV formula

The time value of money concept described here helps us to calculate the present value of a cash flow in a future time period, so we can express future cash flows in today’s dollars (or any other currency). And with NPV we can compare cash flows covering more than one time period.