The Finance Gem 💎 Week #48: Executive Decision Making is Hard

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Welcome to a New Edition of The Finance Gem 💎

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• Accounting and Finance are not the same

• Margin vs. Markup

• 10 Profitability Questions for CEOs

• The CFO’s First Year Checklist

They define value differently.

They have different objectives.

They have different perspectives.

They require different technical skills.

➡️ Knowing how they differ will help you appreciate how they ad value.

➡️ Knowing how they work together will help advance your career.

Here's what you need to know:

⚫ Accounting

🎯 The Accounting approach is backward looking and concerned with compliance against accounting principles and reporting obligations.

🎯 It focuses on smoothing out the results of economic activity over time to match revenues and expenses.

🎯 It's also conservative in the recording and reporting of the results of economic activity.

⚫ Finance

🎯 The Finance approach is forward looking.

🎯 It has evolved in response to Accounting's accrual framework to uncover the true measure of profitability for a business.

🎯 It prioritizes cash and focuses on value creation through capital allocation.

➡️ Remember that despite their differences, Finance and Accounting are complementary, and you need both to drive profitability and growth in your business.

Download a copy of the carousel here.

Do you know your Margin from your Markup?

▶️ Margin shows how much of a product's sales price you got to keep.

▶️ Markup shows how much over cost you've sold the product for.

🎯 Let's dig deeper into each of these . Note we’ll be looking at per unit calculations, but you can easily extrapolate formulas to calculate totals:

1// Margin (or Gross Profit Margin in this case) is the proportion of a product’s Sales Price that exceeds the Product Cost.

☑️ Margin = (Product Sales Price - Product Cost)/ Product Sales Price

☑️ Margin = Gross Profit per Product / Product Sales Price x 100

Note that Margin is calculated as a percentage.

Meanwhile, Gross Profit is calculated as an amount.

To get the Gross Profit Margin you need to divide Gross Profit per Product by the Sales Price per Product and multiply by 100.

2// Markup is the proportion by which you increase the Product Cost to arrive at the Sales Price.

☑️ Markup = (Product Sales Price - Product Cost)/ Product Cost

☑️ Markup = Gross Profit per Product / Product Cost x 100

Note that markup can be calculated based on a product's variable cost or based on its total (absorption) cost.

☑️ Marking up the variable cost could result in under costing and underpricing the product, which in turn may increase revenues at the expense of reduced profitability and cash flows.

💎 Use Cost-Volume-Profit analysis to determine the number of units you will need to sell to break even.

☑️ Marking up the absorption cost could result in over costing and overpricing, which in turn could reduce revenues also at the expense of reduced profitability and cash flows.

💎Be careful with the fixed manufacturing depreciation expense which gets included in the full/absorption cost of a product.

🎯 To calculate your margin if you know your markup: ☑️ Margin = Markup /(1+Markup)

🎯 To calculate your markup if you know your margin: ☑️ Markup = Margin / (1-Margin)

🎯 How to use Margin and Markup:

☑️ Both Margin and Markup calculate the difference between price and cost.

☑️ Margin relates that difference to the product Price.

☑️ Markup relates that difference to the product Cost.

☑️ If you know the Product Cost, use Markup to determine an appropriate selling Price.

☑️ If you know the Product Gross Profit, use it to determine the Gross Profit Margin and track profitability over time.

☑️ And because Price is (ideally) always larger than Cost, remember that Markup will always be the larger metric.

Here’s an example:

Assume a product with a Cost of $20 has a Sales Price of $24.

Margin = (Product Sales Price - Product Cost)/ Product Price = ($24 - $20)/ $24 = 17%

Markup = (Product Sales Price - Product Cost)/ Product Cost = ($24 - $20) / $20 = 20%

If you know the Margin is 17%, then the Markup will be 0.17 / (1-0.17) = 0.20 or 20%

If you know the Markup is 20%, then the Margin will be 0.2 / (1+0.2) = 0.17 or 17%

1️⃣ 𝐌𝐚𝐫𝐠𝐢𝐧𝐬

Q: What are the different levels of our profitability, how to we compare with industry benchmarks, and how do we improve them?

A: Gross, Operating, and Net Profit Margins:

Gross Profit Margin = (Gross Profit / Revenue) x 100

Operating Profit Margin = (Operating Income / Revenue) x 100

Net Profit Margin = (Net Income / Revenue) x 100

2️⃣ 𝐑𝐎𝐄

Q: How can we assess the returns provided to our shareholders and how do we improve them?

A: Return on Equity (ROE):

ROE = Net Income / Average Shareholders' Equity = Profitability x Efficiency x Leverage

3️⃣ 𝐄𝐁𝐈𝐓

Q: How do we evaluate profitability before accounting for interest and taxes and how do we optimize it?

A: EBIT Margin:

EBIT Margin = (Earnings Before Interest and Taxes / Revenue) x 100

4️⃣ 𝐄𝐁𝐈𝐓𝐃𝐀

Q: How does our EBITDA margin track to industry benchmarks and how can we reduce non-operating expenses?

A: EBITDA Margin:

EBITDA Margin = (EBITDA / Revenue) x 100

5️⃣ 𝐂𝐅𝐍𝐈

Q: How to evaluate efficiency in converting our net income into cash flow from operations and how do we improve our cash flow management?

A: Cash Flow to Net Income (CFNI) Ratio:

CFNI Ratio = Operating Cash Flow / Net Income

6️⃣ 𝐑𝐎𝐀

Q: How do we determine the returns we generate on each dollar of assets of the business and how can we optimize our asset utilization?

A: Return on Assets (ROA):

ROA = Net Income / Average Total Assets

7️⃣ 𝐑𝐎𝐂𝐄

Q: How can we enhance our return on capital employed, and are we allocating capital effectively across the business?

A: Return on Capital Employed (ROCE):

ROCE = EBIT/ (Long Term Debt + Equity)

8️⃣ 𝐎𝐂𝐅 𝐌𝐚𝐫𝐠𝐢𝐧

Q: How do we measure how well we convert revenue to operating cash flow ?

A: Operating Cash Flow Margin:

Operating Cash Flow Margin = (Operating Cash Flow / Revenue) x 100

9️⃣ 𝐎𝐏𝐄𝐗 𝐌𝐚𝐫𝐠𝐢𝐧

Q: How can we optimize our operating expense margin to improve profitability?

A: Operating Expense Margin:

Operating Expense Margin = (Operating Expense/ Revenue) x 100

🔟 𝐑𝐎𝐈𝐂

Q: How can we improve our ROIC, and are our investments generating sufficient returns for shareholders?

A: Return on Invested Capital (ROIC):

ROIC = EBIT (1-tax) / (Long Term Debt + Equity - Cash)

Join me for deep cash flow insights and actionable strategies in a power-hour designed for ambitious professionals, executives and business leaders. Learn how to master cash flow, enhance your strategic decision-making, and compound your impact and influence in boardrooms and beyond. Click here to register.

If you thought the CFO role is all about the numbers, think again.

Yes, it’s about KPIs, spreadsheets, accounting principles, internal controls, and management reports.

But it’s also about influencing and guiding decisions to align financial and business strategies.

About strong relationships with your team, stakeholders, and executives.

About strategic thinking, effective communication, strong leadership.

Your first year as a CFO will determine your impact over your tenure.

Because your financial expertise is only half the battle.

-------------

0-30 days: Understand

☑️ review the company's financial statements

☑️understand key revenue streams, and assess profitability trends

☑️engage with both internal and external stakeholders to gain insights on financial projects, audits, and corporate governance.

☑️familiarize yourself with budgeting, forecasting, CAPEX plans, and the company's overall financial decision-making structure

31-90 DAYS: Optimize

☑️develop a financial strategy aligned with company objectives and prioritize cash flow management.

☑️identify and address gaps in KPIs, systems, reporting, and risk management while fostering continuous learning within the finance team.

☑️engage with internal and external stakeholders, leverage technological advancements, and refine strategies based on feedback

91-180 DAYS: Drive

☑️initiate and track the newly developed financial strategies, ensuring alignment with company objectives and regulatory compliance.

☑️monitor risks, refine budgeting, and prioritize resources while evaluating investment opportunities and implementing risk management solutions.

☑️foster strong internal and external stakeholder engagement, explore partnerships, and ensure team cohesion through training and leadership development.

181-365 DAYS: Evolve

☑️review the past six months' financial performance, reflecting on successes and challenges. ☑️refine objectives, plans, and strategies based on evaluations of capital, CAPEX, compensation, and alignment with sustainability goals.

☑️prioritize technological optimization, prepare for market shifts, foster stakeholder relationships, and plan for future leadership succession.

Download a free PDF copy of this checklist here.

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Thanks so much for reading. See you next week.

Oana