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Insights on Financial Ratios:
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Often, executives who change companies and move from one
high-tech sector to another judge their new firm's financial ratios as out of line. Using past experience for benchmarks, these
transplanted executives may not account for some of the valid
differences between industry sectors. Drawing from our High-Tech Financial Ratios service, we report this month on some of the interesting differences between four high-tech industry sectors: Software, Hardware, IT Services and Semiconductor. Gross Profit Margin. The Gross Profit Margin, of course, is what is left of the revenue dollar after deducting Cost of Goods Sold (COGS). Most technology industry executives know this metric differs significantly by industry sector. Since software is supposed to have quite minimal COGS, one might expect to find software companies enjoying 90% or higher Gross Profit Margins. The reality is that most software companies have a significant proportion of revenues flowing from professional services and/or maintenance. The cost of providing these services is much higher than those associated with new software licenses. Services costs notwithstanding, software companies do indeed enjoy higher profit margins. However, the differences are not as great as one might expect. The median profit margin for software companies is currently 66%, compared with margins of roughly 40% in other high-tech sectors (Table 1). |
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Actually, in the Software and IT Services sectors, the so-called COGS, is more often referred to as Cost of Sales (COS). This naming difference is appropriate as there is a minimal amount of goods or materials that goes into the products or services sold in the Software and IT Services sectors. Rather, within these two sectors, the cost is primarily that of the labor required to provide the service in connection with a sale.
| Table 1: Key Ratios by Industry Sector (Medians for Q1 2003, Trailing Four Quarters) | ||||
| Financial Ratio |
Software (n=118) |
IT Service (n=73) |
Hardware (n=84) |
Semiconductor (n=58) |
| Gross Profit Margin | 68% | 42% | 38% | 40% |
| Net Profit Margin | (1.3%) | 3.3% | (0.8%) | (8.8%) |
| Revenue per Headcount | $187,000 | $191,000 | $279,000 | $227,000 |
| Days Sales Outstanding | 66 | 54 | 51 | 50 |
| Price-to-Sales Ratio | 1.8 | 1.2 | 1.6 | 2.6 |
| Source: Financial statement data on 333 companies in the Culpepper High-Tech Financial Ratios database who had filed by June 17, 2003 their 10-k's or 10-Q's for the first calendar quarter of 2003. | ||||
Net Profit Margin. Given the substantial problems reported in the past three years by many of the IT Services companies, this sector presents a pleasant surprise. At 3.3%, its median net profit margin is the highest of the four sectors. All of the other three sectors still post results in the red, with the Semiconductor sector bleeding badly at -8.8%.
Revenue per Headcount. Since sales in all tech sectors have remained at anemic levels, and expenses have not yet been brought in line, Revenue per Headcount remains low. Of our four tech sectors, Software has the lowest Revenue/Headcount at $187,000. However, since Software has such a low COS, it enjoys a much higher Gross Profit Margin than the Hardware and Semiconductor sectors. Thus, Software can afford to run at a lower Revenue/Headcount ratio.
At first it may seem odd that at $191,000, the IT Services sector has only a slightly higher Revenue/Headcount than Software. Since IT Services has the lowest Gross Profit Margin, you might expect this sector would require much higher Revenue per Headcount in order to post a positive Net Income. However, remember that its Gross Profit calculation includes a substantial amount of labor in its deduction for Cost of Sales. If that COS headcount were backed out of the Revenue/Headcount calculation, you would see a far higher Revenue per Headcount for IT Services. In an upcoming article, we plan to show how several ratios like Revenue/Headcount can be normalized between sectors when measured as a percentage of gross profit instead of total revenue.
Days Sales Outstanding. In past articles, we have targeted the problem of the Software sector with its unduly high Days Sales Outstanding. While Software DSOs have come down substantially to 66 days, they still run higher than in other sectors. The DSO issues and their significance are worth reiterating. DSOs will go up due to a number of reasons, none of which have anything to do with the financial stability of the buyer. DSOs will rise when any of the following occur:
While none of the above are problems unique to the Software sector, the first four are subject to far more abuse within that sector than in any of the other sectors.
Price-to-Sales Ratio. Since the Price-to-Sales (P/S) ratio is established by the stock market and not the product-buyers market, the P/S ratio provides a view of prospective, not retrospective, results. While the Semiconductor sector may be drowning in red ink from the past year's results, investors are obviously far more bullish on its future than they are for the other sectors. Semiconductor firms enjoy an impressive median P/S ratio of 2.6. Yet, IT Services, the only sector enjoying profits, suffers with the lowest valuation at a mere 1.2 times sales.
- Warren L. Culpepper
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