The Finance Gem 💎 Week #61: Margin, Markup, CEOs, Linkedin and EBITDA

This week’s issue at a glance:

• 4 Finance Gems 💎 remember to vote your favorite in the poll section

  • Margin is not Markup.

  • Top CEO Errors to learn from

  • EBITDA is Not Cash Flow.

  • Linkedin is Free Education.

• The Financial Analysis Masterclass pre-sale is now on. As a Finance Gem💎subscriber you can save an additional 30% off the launch price. Details below.

• I’ve partnered with Wall Street Prep and Wharton Online to bring you an incredible opportunity to save hundreds of dollars and build your FP&A career. Check out this a one-of-a-kind, theory-meets-practice, FP&A certificate program. Details below.

• My friend Soufyan Hamid launched a value-packed Financial Storytelling Course and his students are loving it. I’ve also secured an exclusive 30% off coupon just for the Finance Gem 💎subscribers, so if you’re looking to elevate your career and influence, check it out below.

• I’d love to get your thoughts on this week’s poll. Share your thoughts below!

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1. Margin is not 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)

🎯 Here’s an example:

Assume a product with a Cost of $50 has a Sales Price of $100

Margin = (Product Sales Price - Product Cost)/ Product Price = ($100-$50)/$100 = 50%

Markup = (Product Sales Price - Product Cost)/ Product Cost = ($100 - $50) / $50 = 100%

If you know the Margin is 50%, then the Markup will be 0.50 / (1-0.5) = 1 or 100%

If you know the Markup is 100%, then the Margin will be 1 / (1+1) = 0.5 or 50%

🎯 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.

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2. Top CEO Errors to learn from right?

Wrong.

These aren’t leadership failures.

They are...

Financial planning failures.

Risk management failures.

Ethical governance failures.

“Those that fail to learn from history are doomed to repeat it.” (Churchill).

So here’s my (very) short list of failures in corporate strategy, financial planning, risk management and ethical governance.

- 𝗡𝗲𝘄 𝗖𝗼𝗹𝗮: Insufficient market research and risk assessment before product overhaul.

- 𝗘𝗻𝗿𝗼𝗻: Misrepresentation of financial health & risk exposure, undermining fiduciary duty.

- 𝗦𝘁𝗮𝗿𝗯𝘂𝗰𝗸𝘀: Misallocation of capital in aggressive expansion without market demand analysis.

- 𝗦𝗲𝗮𝗿𝘀: Neglected investment in e-commerce infrastructure in the face of digital retail growth.

- 𝗨𝗯𝗲𝗿 Ignoring long-term financial costs of toxic corporate culture on litigation and brand value.

- 𝗕𝗼𝗲𝗶𝗻𝗴 𝟳𝟯𝟳 𝗠𝗮𝘅: Underestimated financial and reputational costs of compromising on product safety.

- 𝗔𝗢𝗟 𝗧𝗶𝗺𝗲 𝗪𝗮𝗿𝗻𝗲𝗿 𝗠𝗲𝗿𝗴𝗲𝗿: Write-downs following misjudgments in valuation, synergies and integration.

- 𝗚𝗲𝗻𝗲𝗿𝗮𝗹 𝗘𝗹𝗲𝗰𝘁𝗿𝗶𝗰: Strategic overreliance on financial engineering at the expense of core innovation investment.

- 𝗦𝗮𝗺𝘀𝘂𝗻𝗴 𝗚𝗮𝗹𝗮𝘅𝘆 𝗡𝗼𝘁𝗲 𝟳: Overlooking the financial impact of quality control failures on brand and market position.

If you would like to add to this list, feel free to reply to this email.

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3. EBITDA is Not Cash Flow

EBITDA is Not Cash Flow.

🎯 It is however a necessary evil, and whether you like it or not, it’s here to stay.

🎯 EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is calculated just as the name implies:

E >> Earnings (Net Profit)

B >> Before (add back)

I >> Interest expense

T >> Tax expense

D >> Depreciation expense

A >> Amortization expense

🎯 Here are 3 Benefits of EBITDA to know:

1️⃣ It is easy to calculate.

As opposed to Operating Cash Flow (OCF), Free Cash Flow (FCF) or Economic Value Added (EVA).

2️⃣ It has become universally used as the language of (proxy) Profitability.

Or Cash Flow, depending on who you talk to, and what they use it for.

☑️ Your company likely uses it to manage internal performance.

☑️ Your bankers use it to measure your ability to repay debt.

☑️ Your M&A firm will use it to value your business.

3️⃣ It allows you to compare financial performance results across businesses and industries.

It (presumably) levels the playing field by removing the impact of several variables from the financial analysis:

☑️ the company’s capital structure (removes the interest)

☑️ the company’s operating leverage (removes depreciation & amortization expense)

☑️ the company’s tax circumstances (removes the tax expense)

➡️ And here are 10 Critical Flaws of EBITDA:

1.     It is not a GAAP metric.

Which means there is no standardized formula to calculate it, and companies will choose to calculate it however it benefits them most.

Such as in the case of Earnings per Share, when a company may exclude stock based compensation from its GAAP earnings while another may not.

2.     It implies that all net income translates into cash the same way.

For example, using EBITDA as a proxy for cash flow ignores the required investment into working capital assets to support the business future growth.

3.     It does not consider the amount of required capital reinvestment.

While Depreciation and Amortization may be non-cash items, every business has CAPEX investment needs which aren’t captured in EBITDA.

4.     It does not account for the amount of cash absorbed into working capital assets.

Changes in receivables, payables and inventory balances can mean that an EBITDA of $1 million disguises the reality of an operating cash flow deficit of $2 million.

5.     It implies that loan repayment will be prioritized.

In fact, a company may choose other uses for its cash, such as investing in growth, acquisitions or plant capacity expansions, and leave no residual capital left to repay loans.

6.     It doesn’t say anything about the quality of earnings.

Which means earnings and EBITDA may be inflated with deferred expenses, aggressive accounting policy choices, or underfunded pension liabilities.

7.     It is a poor measure of profitability.

For example, GAAP revenue recognition criteria differs around the world which can overstate earnings; meanwhile, interest and taxes are usually real cash outflows which reduce earnings in practice.

EBITDA’s ability to proxy for cash is also distorted in all instances where revenue recognition doesn’t correlate with the receipt of cash, such as percentage of completion in long term contracts. In those instances, customers are billed in accordance to contractual terms, while the company recognizes revenue based on costs incurred, and the true profitability of the contract could be wildly overstated until it is actually completed.

8.     It is an inadequate comparison for acquisition multiples.

EBITDA doesn’t capture industry specific capital investment requirements nor company specific underlying strength in operating earnings.

It is trying to level the playing field and strip out so-called noise from the profitability picture of a company, but when the noise is inherent in the make up of an entire industry, stripping out critical components like CAPEX maintenance results in a distorted image of the earnings potential of that entity.

9.     It can be severely misleading when used as a measure of cash flow.

EBITDA ignores several real cash outflows as well as understates the future expected increase of those cash outflows.

10.  It can easily be manipulated through aggressive accounting policies.

There are numerous financial reporting areas where management can manipulate company earnings and artificially inflate EBITDA, such as with percentage of completion revenue recognition, deferred expenses, pension liabilities, or depreciation assumptions.

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For 𝗙𝗥𝗘𝗘.

➡️ 𝗔𝗹𝗹 𝘆𝗼𝘂 𝗻𝗲𝗲𝗱 𝗶𝘀 𝗮 𝗟𝗶𝗻𝗸𝗲𝗱𝗶𝗻 𝗣𝗿𝗲𝗺𝗶𝘂𝗺 𝘁𝗿𝗶𝗮𝗹. Cancel it after 30 days and you won't get charged.

You'll get 30 Days to explore and take all the courses you need to grow your skills and knowledge in finance and accounting.

➡️ 𝗛𝗲𝗿𝗲'𝘀 𝗺𝘆 𝗰𝘂𝗿𝗮𝘁𝗲𝗱 𝘀𝗲𝗹𝗲𝗰𝘁𝗶𝗼𝗻 𝗼𝗳 𝟮𝟬 𝗲𝘅𝗰𝗲𝗹𝗹𝗲𝗻𝘁 𝗰𝗼𝘂𝗿𝘀𝗲𝘀 𝘁𝗼 𝗵𝗲𝗹𝗽 𝘆𝗼𝘂 𝗴𝗲𝘁 𝘀𝘁𝗮𝗿𝘁𝗲𝗱.

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