When a recession hits, it is important for businesses to closely monitor their performance. The goal is to work smarter, not harder — so rather than combing through data, businesses should keep their fingers on the pulse of two key ratios.
In this installment of the blog series about what businesses should do during a recession, learn the two ratios that all businesses should vigilantly monitor:
- Gross margins
- Overhead as a percentage of revenues
GROSS MARGINS: WATCH PROFITABLE OPERATIONS
Gross margins are the result of dividing gross profit (sales less cost of goods sold = gross profit) by sales. Before a recession, it is vital to be proactive and review gross margins in order to adjust practices and maximize profits.
Every business will have different metrics by which to measure. For example:
- Many manufacturing businesses have gross margins ranging from mid-to-high 20 percent to mid-to-high 30 percent
- Distribution companies may have gross margins of less than 20 percent
- Software businesses typically have very high gross margins above 70 percent with new users adding little to no cost per new user
Business owners must benchmark their company against industry norms to understand if they are above or below average.
Firstly, confirm that your financial statements are classified correctly. Very often, financial statements can misclassify expense lines into the wrong section on the profit-and-loss statement. A good example of this would be a service business that categorizes the employees who deliver the service in the overall salary line, combined with management and administrative staff, instead of carving out those employees into the cost of goods sold (COGS). Another common example is misclassifying freight or shipping costs into overhead instead of COGS.
A best practice is to measure gross margins by product, by distribution channel and by customer. Analyzing the business based on these segments allows the business to identify any lower-than-average margins. This should lead the business to adjust their strategy, whether that is through eliminating lower-margin products or customers, rechanneling the business through different means or raising prices/lowering costs to bring a segment into line with the rest of the business. Conversely, it also can mean doing more business through higher-margin opportunities.
As part of the forecasting creation work done by GHJ, our team starts by analyzing historical trends by product, channel and customer. Then we ask clients probing questions to create a forecast that is robust and useful.
OVERHEAD AS A PERCENTAGE OF REVENUES: KEEP AN EYE ON THE HEALTH OF THE BUSINESS
For overhead as a percentage of revenues, this percentage should generally be declining as revenue increases because many of these expenses are fixed in nature without regard to size (e.g., rent, management salaries to the extent that the team is appropriately sized for the business, equipment leases, etc.).
When revenues decrease, perhaps because of an economic downturn, companies should examine what overhead costs will not be necessary in a reduced sales environment. If the ratio is getting larger as a percentage of sales, search out those expenses where reductions can be implemented without jeopardizing the health of the business. An experienced third party can help identify the ramifications of any particular business decisions.
Another number to keep an eye on: Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Companies that generate EBITDA as a percentage of revenues in excess of 15 percent are much more valuable than those below 15 percent (unless it is a distribution business with faithful and longstanding customers).
To learn more about how businesses should prepare for and respond to a recession, contact GHJ’s Growth Planning and Strategic Advisory team.
