How a CFO Evaluates Profitability using Metrics

In today's lecture, we'll be talking about how a CFO evaluates the profitability of a business using two important profitability metrics, gross margin versus profit margin. So, we'll

talk about the calculation and the insight that you get from each of these two. And if you understand them really

two. And if you understand them really well, you can read the financial health of a company in just minutes. So, if you like this topic, let's dive right in.

Bill Hannah here, your favorite financial controller. I've been in the

financial controller. I've been in the accounting and finance game for the last 20 years, worked my way up to a controller position and most recently took a role as a director of finance at

a software company in New York City. So

before jumping into today's topic and looking at the example that we have here, I want to talk about the why. Why

do we evaluate gross margin and profit margin? The reason is this drives our

margin? The reason is this drives our product strategy. So which product do we

product strategy. So which product do we make uh and sell and how much do we sell them for? how much do we spend on

them for? how much do we spend on producing them and things like that. It

also influences hiring. So, uh

influencing hiring less or more is going to be dependent on our profitability. It

also influences our business decisions overall. So, these are things like which

overall. So, these are things like which location do we set up the manufacturing and selling at um what kind of marketing spend are we going to have and things like that. This is all is derived from

like that. This is all is derived from the profitability metrics that we have here. Okay. So we have here an income

here. Okay. So we have here an income statement for the Fininoco Inc. We have revenue of 500,000, COGS of 200,000 and that uh result in a gross profit of

300K. Operating expenses are 150,000 and

300K. Operating expenses are 150,000 and then we have taxes and interest of 50,000 leading to a net income of 100,000. Okay, so let's go ahead and uh

100,000. Okay, so let's go ahead and uh calculate gross margin. So our gross margin here is going to be revenue minus COGS divided by revenue. So revenue

minus COGS is right here is gross profit 300K. So this is 300K

300K. So this is 300K divided by our revenue which is 500K

and that equals to 60%. Now what does that say to us? 60%. That says that for every dollar that we sell in product we make 60 cents in gross profit before we

spend on other things like operating expenses, taxes and interest. Right?

This is just 60% that we make right out of the gate after we sell our product just subtracting our COGS. Okay, so that is for uh gross margin. Let's go ahead

and calculate profit margin. So profit

margin formula is net income divided by revenue. So net income that we have here

revenue. So net income that we have here is $100,000.

So we have 100k divided by revenue 500k and that equals to 20%. Which is saying

that for every dollar that we sell in revenue we make 20 cents in net profit.

That's why we call it profit margin.

Sometimes we call it net profit margin or net margin. Profit margin. Net profit

margin. The same thing. All right. So

now that we've calculated our profitability metrics, how do we know where we stand as a company? So we have a gross margin of 60%. How do we know if that's good or bad? So you need to

benchmark this against other companies in the same industry. So to give you an example of this, when I was a mid mid-career, I worked as a controller at a food manufacturing company and our

gross margin was about 30%. So 30% in food manufacturing is actually a good gross margin, right? But now that I worked at a software company, the gross margin is somewhere about 80 to 90%.

typical gross margin for a software company around that rate. Right? So you

need to benchmark this and you can ask Chad GBT or another AI tool here's my industry here's my gross margin is this typical this low or this high right so you got 60% in this case what insight do

we get from this number well the insight that we get is a product related insight meaning is our unit price too low so maybe if you're selling something for a

dollar it needs to be sold for $120 in this case right is your cost to produce too high right all the things that go into producing a it uh the ingredients

or material, direct labor, and your overhead. All of these things that go

overhead. All of these things that go into producing the product. Is this too high? And that's why your margin isn't

high? And that's why your margin isn't doing so great. Is your supplier cost too high? So, you need to visit the

too high? So, you need to visit the suppliers that you're sourcing your ingredients from and figure out are you paying the optimal price or are they are there other suppliers where you can

engage with that have a better pricing for your ingredients. Okay. Okay. So

this is the kind of insight that you get from a gross margin calculation. With

profit margin, uh this is about the business operation overall. This is not about the product. The product is the gross margin. With profit margin, this

gross margin. With profit margin, this tells you whether the rest of the business is operating effectively.

Right? So these are things like selling and marketing. Are you spending the

and marketing. Are you spending the right amount on selling or marketing? uh

maybe your spend there is too high and that is affecting your operating expenses and making this number too low as a ratio. So you need to spend some time looking at your selling and marketing cost. You need to be also

marketing cost. You need to be also looking at GNA, general and administrative costs. These are things

administrative costs. These are things like the rent that you pay, uh some of the salaries, uh legal cost, finance costs, things like that. This is going to be under your GNA. So you need to be

uh spending some time on that. The same

can be said for R&D. Maybe you're

spending too much in R&D and that is co causing your opex to be too high driving this ratio down. The other thing is going to be depreciation and interest.

So depreciation is included in a calculation of profit margin because you're taking net income divided by revenue. So depreciation might be too

revenue. So depreciation might be too high if you are not using the correct useful life for your assets. You might

have a too high of a depreciation. So

you need to be revisiting that and looking into it. uh with interest that goes into the calculation as well. If

you are paying interest in an outstanding loan, uh you might want to look at that and maybe refinance and negotiate with the bank if you're spending too much on interest. So these

are the things that typically a CFO would analyze and figure out which area of the business is causing this weakness that is leading to a low uh profit margin. All right, so now that we talked

margin. All right, so now that we talked about the calculation and the insights that we get from these metrics, let's talk about a summary of these things. So

for gross margin, the cost that goes into the calculation is COGS, cost of goods sold. While with net margin, it's

goods sold. While with net margin, it's going to be all of your costs. So this

is going to be your opex and depreciation amortization and interest. With the profitability, with

interest. With the profitability, with gross margin, we're looking at the product profitability from every unit that we're selling in product. How much

are we extracting in profit before we talk about all the other operating expenses? Only product. Whereas with net

expenses? Only product. Whereas with net margin, we're talking about the business profitability, the overall business profitability.

With the insight, the insight that we got from gross margin gave us insight into the efficiency of production and pricing. Are we pricing our products at

pricing. Are we pricing our products at the right price? Are we producing them at an efficient enough price so that we extract the most profit out of it? With

net margin, the insight that we get is going to be related to the overall financial performance and management of the business. So understanding these

the business. So understanding these metrics here is going to help you make better business decisions, analyze performance of the business, and think like a controller or CFO. If you wanted

to get deeper into these concepts, go ahead and check out my CFO program on my website, the Controller Academy. I'll

leave a link to that down below. If you

like the video, give it a big thumbs up and share it with someone that you know who benefit from learning these concepts. And I'll see you on the next

concepts. And I'll see you on the next video.