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The Importance of Gross Margins and Cash FlowIt is every investor’s dream to find the next Microsoft or Cisco Systems early on and ride them to monstrous gains. However, finding these stocks is tough since most early-stage growth companies don’t have any earnings, and usually just a great story to trumpet. There are more cases of investors losing their shirts buying these kinds of stocks than there are success stories of huge winners. Since few young growth companies are profitable, what should you be on the lookout for? Gross margins and cash flow are two vital metrics to follow when analyzing early-stage companies.
Sizzle, but no Steak
Younger companies must spend heavily to expand their nascent businesses and gain a foothold in their markets. This is expected and even necessary. The logical result of this is for the company to show losses in the first few years of its lifetime. That being said, you should not give a company a free license to bleed red ink ‘til kingdom come. It is crucial to determine whether or not the company is on the path to profitability.
Profit Margins
Early-stage companies exhibit explosive revenue growth, but how efficient is the management team in turning those sales into profits? Calculating a company’s profit margin is an excellent way to examine how a company generates and retains money.
Gross margin is the best tool to analyze a young company’s potential for profitability. This tells you the profit made on the cost of sales. Basically, it is how efficiently management uses labor and supplies in the production process. It can be calculated using the following equation:
Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
For example, assume that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1,000,000 - $600,000/$1,000,000). The static number (40%) is important, but less so than the trend. Be on the lookout for increasing gross profit margins, as this could be a telltale sign of a company on the path to profitability.
Another reason increasing gross margins are important has to do with research and development. Early-stage companies, especially in the biotech and technology sectors, need money to invest in R&D, which is the lifeblood of a young company. Firms with increasing gross margins will have more cash to invest in the future of their businesses.
Feel the Flow
Sometimes, young companies do not survive long enough to realize the glory of their dreams because they don’t have adequate cash on hand to fund operations. If a company burns through its cash too fast, it runs the risk of going out of business. So what should you look for?
Operating cash flow is simply the cash generated by a business while running its “normal” operations. Think of a company’s normal operations as its core business. For example, Dell’s normal operations are selling personal computers. Cash flow is absolutely vital because it allows a company to pay its bills on a daily basis. Operating cash flow can be found on the company’s statement of cash flows.Look for young companies that are cash flow positive, even if they are losing money overall. Positive and growing operating cash flows will ensure a company’s survival. After all, not many bankrupt companies can grow to be the next Microsoft.
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