In a financial model it is common to see measures of profitability averaged historically and projected forward. This is, after all, the manner in which building a five-year projection is presented in “Integrating Financial Statements” on this website. As an introduction to financial modeling this is a suitable approach, but as you graduate from projections built off of fictional historical data to real-world modeling exercises, attention should be paid to the detail that comprises expenses.
When the detail is incorporated, many line items are likely to be projected in line with historical averages as well. But there are expense categories for which a historical average may not be appropriate, and the clever ways these items are projected can be quite interesting.
Analysts at Wells Fargo recently employed a creative method to determine the potential impact of a drop in the price of cotton on a select group of retailers. The WSJ blog MoneyBeat reports:
Wells Fargo weighed a short-sleeved graphic T-shirt, a hoodie and a pair of denim jeans from Abercrombie & Fitch, Aeropostale, American Eagle Outfitters and Gap to figure out the value of the cotton in each. A pair of American Eagle jeans, for example, weighs 1.4 pounds and sells for $34.30. At 63-cents-a-pound, the value of the cotton is 86 cents, versus $1.04 a year ago when cotton cost 76 cents a pound — a savings of 18 cents.
Cheaper cotton should generate an average benefit to gross margin, across all three clothing items, of about 0.58 percentage points, the bank found. But the bottom-line gain wouldn’t be as large. The retailers sell non-cotton items. They face rising costs for labor, transportation and safety standards. And many companies buy fabric, not raw cotton. Any of these factors could easily wipe out the benefit.
As the excerpt points out, another important variable to consider is the potential impact to the bottom line. If you were to take a look at all of the line items that comprise Cost of Goods Sold (COGS), you would want to look for line items that might fluctuate and stand to make an impact.
Naturally the objective would be to focus on all large expense categories, but it is also important to keep overall profitability in mind. The narrower the margins the more important this detail becomes. Half a percent may not mean much if a company operates at 30% EBITDA margins, but at 5% EBITDA margins your profitability swings 10%.