By: Wesley Legg
As healthy companies grow, they generally see margins expand as fixed costs are diluted with increased sales or as the company gains pricing power. Therefore, compressing margins can be a leading indicator of issues arising within a business.
Perhaps a business has not invested sufficiently in R&D, so their technology is becoming obsolete. This could result in the need for increased Sales & Marketing efforts to achieve historical levels of revenue resulting in margin compression. Perhaps the company’s capital structure is not optimized resulting in excessive interest payments cutting into margins. Or maybe a new competitor has entered and there are new pricing pressures.
Regardless of the origin, contracting margins generally indicate there is opportunity to improve and can be somewhat off-putting to investors. Management should investigate the source of their margin compression by building a gross margin bridge using the template below.