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Due Diligence – How to Analyse an Income Statement

For those desiring to do Due Diligence, before joining an MLM Company, one step is to look at the Income Statement and Operating Ratios (compared to Industry Statements). This information can normally be found on the Websites of Public Companies (Investor Relations) and the D&B reports of Private Companies (for a small fee paid to your Bank). Financial statement studies can be found in the business section of a local library or online. Because many people don’t have financial accounting backgrounds I will simplify this to the bare bones.

As an example, here are the operating ratios of a Public Health and Wellness Company (Mid-sized) for the last three years. I am not interested in the ratios below Income from operations unless it looks out-of-line and the company has bottom-line profit issues (read all footnotes).

Year ended December 31, 2006 2005 2004
Net Sales 100.0% 100.0% 100.0%
Cost and expenses:
Cost of products sold 16.6 17.0 17.2
Distributor royalties and commissions 40.1 40.0 39.8
Selling, general and administrative 33.0 32.0 33.7
Income from operations 10.3 11.0 9.3

At first blush, one really good sign is the “cost of product ratio.” As you can see the cost of the products went from 17¢ on the dollar to 16¢ on the dollar. If they take a price increase on the Distributor (customer) they better have a good reason. They should be able to hold prices. On the flip side, the fact that Distributor Commissions have not decreased is also a good sign for you and should make it easier to retain the people you recruit. Don’t worry, this is just as critical to them as it is to you assuming the company has good management and acts rationally. You can determine that by looking at how well the ratios are maintained over the last three years, and by reviewing the Board of Directors and Operations Management.

In accordance with GAAP you will notice in their footnotes: “Product sales represent the actual product purchase price typically paid by our distributors, after giving effect to distributor allowances, which can range between 20% to 40% of suggested retail price.” In other words, product discounts are not included in the 40¢ on the dollar commission expense. They correctly record this as a deduction in the Suggested Retail Price (GAAP). Also, you will notice that Freight Income is in Net Sales and the cost of freight to ship products to the Distributors is in the Cost of products sold. The fact that the maximum wholesale discount is 40% is a “great” sign because of the psychology of selling. The closer a company can come to that magical figure “50% off” the better.

No matter what the Company may tell you about Commission Expense, the average cost of the Distributors is 40¢ on the dollar.

It’s time to look at the all important Break-Even Sales figure and the “KEY” ratio (Gross Profit):

Year ended December 31, 2006 2005 2004
Net Sales 100.0% 100.0% 100.0%
Cost and expenses:
Cost of products sold 16.6 17.0 17.2
Distributor royalties and commissions 40.1 40.0 39.8
Variable Cost 56.7 57.0 57.0
Gross Margin 43.3 43.0 43.0
Fixed Cost:
Selling, general and administrative 33.0 32.0 33.7
Income from operations 10.3 11.0 9.3

Gross Margin is a Key ratio because it tells you a lot about a company:

  • Does this company have serious profit potential (ROS – good health) or not?
  • Or, is this a marginal company that can never pay you well and it’s time to look somewhere else?

As is normally the case with Health and Wellness Nutrition companies, this company has tremendous profit potential (and their bottom-line income reflects that fact too). Once they get past fixed cost (Break-even Sales Volume) they make 43¢ on each dollar of net sales. How would you like to make a 43% return on your Distributor sales (ROS) before tax? Of course, the Key is Break-Even (Net Sales).

And so, what’s their break-even net sales? If you review their income statement you will find the S,G&A (Fixed Cost) is $39 million dollars. We divide $39 million by 43 percent and get the Break-even Net Sales Volume = $90 million dollars (approximately).

What if their Break-even Net Sales Increases by $10 million? Well, they will make 43¢ on the dollar or $4.3 million in profit before tax.

What if Break-even Net Sales Decrease by the same $10 million? Well, they will lose $4.3 million.

And so, what are the Key Variables in this analysis and what should this company watch:

  • Net Sales (Recruiting and Retention)
  • Fixed Cost (within a normal range of operations)

As you can see, this is why you have Financial Analyst looking at financial statements trying to find the easy mark. The easiest thing to control is FIXED COST and they are looking for any easy target out there to acquire. Obviously, doing the easiest thing is not always the expedient thing. If fixed cost are well within industry ratios and have already been controlled to the Nth degree what is your option? Well, I only see a few but the obvious thing is to grow Net Sales.

If you are like me, you would love the opportunity to grow sales and have a great time doing it. That’s why my wife and I do Network Marketing in this Industry!

Here is a comparison of a few companies (see their company financial statements and footnotes). These comparisons are for illustration purposes only and are not to be relied upon for financial or other decisions:

FYE Dec. 31, 2006 Herbalife* Reliv Usana Mannatech
Net Sales 100.0% 100.0% 100.0% 100.0%
Cost and expenses:
Cost of products sold 20.2 16.6 23.9 14.3
Distributor royalties 35.8 40.1 39.1 44.4
Variable Cost 56.0 56.7 63.0 58.7
GrossMargin 44.0 43.3 37.0 41.3
Fixed Cost:
SG&A, R&D 30.4 33.0 20.4 30.6
Income from operations 13.6 10.3 16.6 10.7

*Herbalife makes this comment in their footnotes, “Royalty Overrides together with distributor allowances represent the potential earnings to distributors of up to approximately 73% of retail sales.” That’s because discounts (from gross sales) account for approximately 50% off retail sales prices.

“Not everything that can be counted counts, and not everything that counts can be counted.” Albert Einstein

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