The profit margin is a profitability financial ratio, given by the net income divided by the net sales, and multiplied by a hundred. That is expressed as a percentage. That is a key profitability measure as combined with other financial metrics, it helps assess the overall viability of a business model.
Do profit margins still matter?
In the era of digital platforms, many of which are unprofitable, the question of whether profitability still matters becomes the subject of discussion here and there.
I want to shed some light on why profitability still matters, and in which exceptions we can give up profitability for something else.
In short, there are some cases, where lack of profitability becomes a deliberate financial and operational strategy, where companies give it up because they are focusing on some other aspects of the business.
Free cash flows in place of profit margins
Jeff Bezos recounted in a shareholders’ letter, back in 2006:
As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible.
This might seem a trivial decision now, that Amazon turned into a tech giant. Yet, back then Jeff Bezos also highlighted:
However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more.
He had an important point, which he could not back up with that, but only with business intuition. As he further explained:
Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com.
What was puzzling at the time, would become one of the most important choices Amazon made.
Netflix is a profitable company, which net profits were $5.1 billion in 2021. Growing from $2.7 billion in 2020. The company runs a negative cash flow business model, where it anticipates the costs of content development and licensing through the platform. Those costs get amortized over the years, as subscribers stick to the platform.
For many years, Amazon has been unprofitable or barely so, as it was deliberately prioritizing, both at the operational and financial levels free cash flows, which could be used to unlock shorter-term growth for its operations.
In order for that mechanism to work, Amazon had to make sure to have fast inventory turnover, fast cash collection from customers, and slower payments to third-party sellers/suppliers.
The cash conversion cycle (CCC) is a metric that shows how long it takes for an organization to convert its resources into cash. In short, this metric shows how many days it takes to sell an item, get paid, and pay suppliers. When the CCC is negative, it means a company is generating short-term liquidity.
As a reference, even during the pandemic Amazon managed to unlock substantial cash from operations, which is used to make its inventory level faster, its delivery shorter, and its service more widely available.
Amazon has a diversified business model. In 2021 Amazon posted over $469 billion in revenues and over $33 billion in net profits. Online stores contributed to over 47% of Amazon revenues, Third-party Seller Services, Amazon AWS, Subscription Services, Advertising revenues, and Physical Stores.
Once again, the lack of profitability, for several years, has been exchanged in place of free cash flows and growth.
The free cash flows unlocked enabled Amazon to build a better infrastructure, further lower its prices, improve the variety of products on the platform, expand globally, and launch new products and segments.
Long-term assets in place of profit margins
Netflix is a subscription-based business model making money with three simple plans: basic, standard, and premium, giving access to stream series, movies, and shows. Leveraging on a streaming platform, Netflix generated over $29.6 billion in 2021, with an operating income of over $6 billion and a net income of over $5 billion. Netflix is a profitable company, which net profits were $5.1 billion in 2021. Growing from $2.7 billion in 2020. The company runs a negative cash flow business model, where it anticipates the costs of content development and licensing through the platform. Those costs get amortized over the years, as subscribers stick to the platform.
When Netflix turned to original programming, back in 2013, it wasn’t a simple choice, it meant the transition from an entertaining platform to an entertaining brand.
Binge-watching is the practice of watching TV series all at once. In a speech at the Edinburgh Television Festival in 2013, Kevin Spacey said: “If they want to binge then we should let them binge.” This new content format would be popularized by Netflix, launching its TV series all at once.
In short, Netflix was building up the assets that would lead to a whole new business model, with a stronger brand, proprietary content, strong tech infrastructure, a much larger subscription base, better distributionmodel.
In addition, over the years, Netflix gained more freedom over content formats, programming, and the distribution of that content on its own platform.
Economic or market moats represent long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
As Netflix was building up its assets, it was running at lower profits margins and negative cash flows (it still does), but it was also gaining market shares, in a competing industry, with established, long-time players (like Disney).
As Netflix’s business strategy rolled out (this transition took almost a decade) Netflix became as valuable (from a market standpoint) as Disney.
As Netflix gave away operational and financial efficiency, it gained market shares and expanded the video streaming market, thus expanding the overall value of the company.
Example of how over the years Netflix expanded as a result of surfing and creating new markets. What’s next?
Key takeaway
Profitability is extremely important to evaluate businesses. Indeed, as the market conditions change quickly, the companies that are most sustainable from a profitability standpoint might also be the ones surviving.
However, for a period of time, a company might be giving up profitability as a deliberate strategy to:
Unlock more cash for growth: like Amazon’s case shows, you can pass lower prices to customers, further grow the platform and still have plenty of cash left for expansion.
Build long-term assets that create moats: moats are business defenses that companies build up over the years as they expand their strategic assets. As in the Netflix case study, the company gave up years of profitability (and it still does) in exchange for building up assets that changed and are still changing its business model.
Gain market shares: in some other instances companies might be giving up profitability to gain market shares.
In most other cases, where companies are simply not profitable, because they could not pull off a proper business model, that’s an example of a company that isn’t viable, yet.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
Business analysis is a research discipline that helps drive change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.
The cash flow statement is the third main financial statement, together with the income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing, and financing. The cash flow statement can be prepared with two separate methods: direct and indirect.
A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis, it is possible to understand the competitive landscape of the target organization.
The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.
Economic or market moats represent long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory for companies for tax purposes. They are also used by managers to assess the performance of the business.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
