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Principles of Finance: Unit 4, Review of Margins as They Apply to Inventory Management 4 Views


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Description:

How do margins apply to inventory management? We'll cover the two primary drivers of share price - margins and revenue growth.

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Transcript

00:00

Principles of finance ah la shmoop review of margins as

00:06

they apply to inventory management All right people as a

00:09

financial manager a big part of your report card will

00:12

come from how you're doing relative to competitors into key

00:16

categories and these air the primary drivers of share price

00:20

overtime Yeah margins and revenue growth revenue growth not just

00:26

revenue if you're in the sunglasses business while they're just

00:29

a handful of large scale competitors one growing revenues at

00:33

thirty percent with twenty five percent operating margins is going

00:35

to trade at a big multiple premium toe one growing

00:39

revenues that only ten percent with fifteen percent margins Right

00:42

Multiple of what Yeah Good question Glad you asked burnings

00:46

or cash flow or a composite of the two All

00:49

right we'll come back to that What if you're in

00:51

the lemonade delivery business So take a look at this

00:54

before we get started You remember eliminate stands are us

00:57

income statement here Twenty nineteen margins All right So that's

01:02

the income statement lemonade stands are us Note the margins

01:06

there for the moment Focus here is on these margins

01:09

Inventory is an expense I either cost structure of the

01:13

ingredients that go into a product or service like plastics

01:16

and glass and you know to hinges pushing forward our

01:20

lemonade stand metaphor Here we've decided to include on ly

01:22

the cups and the liquid as costs that go against

01:25

gross margin so that we have very high gross margin

01:29

product in our lemonade at eighty five percent Well how

01:32

do people get served ignoring labor How do they pay

01:36

ignoring visa and mastercard Do robots or ghost magically do

01:40

this No maybe labor should go up There is part

01:43

of the gross margin expense Maybe not We'll think about

01:46

it anyway In the case of lemonade business if the

01:48

costs of the cups doubled and the cost of sugar

01:51

and lemons went up fifty percent that is instead of

01:54

ten cents a cup it cost twenty and instead of

01:56

a nickel it was seven and a half cents for

01:58

the sugar and lemons but we'd still have a really

02:01

high margin business Gross unit margins would be a dollar

02:05

minus twenty cents for the cups minus seven half cents

02:08

for the sugar and lemons and that give us a

02:10

gross unit profit of seventy two and a half cents

02:12

A cup was ninety seventy two still really good Well

02:15

the key idea here is that inventory management and price

02:19

optimization for those kinds of inputs doesn't matter all that

02:22

much In this case if a can of coke sells

02:25

for a buck and sugar prices double well that can

02:28

produces seventy cents of profits instead of eighty or something

02:31

like that in very high margin business is you don't

02:34

go bankrupt if input costs go up your just less

02:37

wildly profitable And in reality you pass along those price

02:41

hikes to consumers usually pretty easily Yeah all right but

02:44

what about the low margin airline industry where fuel is

02:47

a huge part of expenses and its pricing is extremely

02:51

volatile What happens then Well in times of falling fuel

02:54

prices assuming they aren't reflective of a failing economy or

02:58

that star trek thing or the i dream of jeannie

03:01

thing where she just blinks and then appears like four

03:03

thousand miles away and that air travel and economic times

03:06

were highly correlated So you know the airlines are more

03:08

profitable than otherwise In this example things can whips off

03:11

fast in the airline industry and in the economy one

03:14

bomb goes off in the middle east and fuel prices

03:17

double overnight and airlines hemorrhage losing money so inventory management

03:21

is hugely important there The inventory of fuel So is

03:25

capital management in the notion of how much margin life

03:29

insurance companies are willing to pay for a given amount

03:32

of protection All right wait What is marjan life insurance

03:35

What is that Well it's hedges that is most airlines

03:39

purchase forward contracts giving them the right to buy fuel

03:45

like airline fuel for a set price per gallon for

03:48

a set period of time Like they know roughly how

03:51

much fuel they're going to consume in april of next

03:54

year in august of next year and maybe eighteen months

03:57

forward from that because their business pretty steady So they

03:59

buy future contracts toe lock in their prime ice is

04:02

so like you know knows surprised if that bomb does

04:05

go off in the middle east Alright so example here

04:08

we go that is if you'll today is sixty bucks

04:10

a barrel of oil Jets fly jet a fuel usually

04:13

But pricing is highly correlated to the pricing of a

04:16

barrel of oil so we'll just use that now for

04:19

our proxy because it's more liquid So if oil is

04:22

sixty bucks a barrel today and the airline industry is

04:25

okay feeling the pain of a fuel hike all the

04:27

way to eighty bucks a barrel But beyond that eighty

04:30

dollars they want a hedge half their exposure up to

04:33

one hundred dollars a barrel meaning we'll split the difference

04:36

of ten bucks up to one hundred dollars when it

04:38

then wants to hedge all of it like if prices

04:40

go above one hundred bucks a barrel they'll just pay

04:42

a lot of money for life insurance above there And

04:45

the forward contracts will then reflect that and protect their

04:48

margin and manage their quote Inventory costs unquote All right

04:51

so why is all this important Conceptually because fuels aki

04:55

volatile inventory input element of the airline industry it's low

04:59

margin and so their life is threatened if fuel prices

05:02

go really really high really really suddenly the hedges purchased

05:06

by the airlines are essentially profit margin life insurance When

05:11

fuel prices do go up a ton you know they

05:13

always do All right Well when that happens the airline

05:16

industry doesn't go bankrupt They can pass along a lot

05:19

Of the fuel price hikes to customers in the form

05:21

of higher ticket prices because well all of their comm

05:24

editors smartly hedge their fuel costs and can still offer

05:28

the sfo jfk leg for four hundred sixteen bucks You

05:31

can imagine if you're the one airline who didn't hedge

05:34

and everyone else can drop the prices of four sixteen

05:37

and break even in your break even prices five eighty

05:41

well then we suggest glass door or indeed either those

05:45

are pretty good places to find a job here's a

05:51

simple example lacking detailed accuracy so that it's relatively clear

05:55

so we're not going to get lost in the weeds

05:57

here Shmoop west airlines uses ten million barrels of fuel

06:01

a year It believes that oil prices will rise because

06:05

the economies of the world have improved and that air

06:07

travel will remain robust so they don't think they'll fly

06:11

Heavier planes burn more fuel on more packed flights or

06:14

more routes All else is held the same shmoop west

06:18

wants to hedge five million barrels for next year so

06:22

it looks at the derivatives trading desk and has offered

06:25

for eight dollars a barrel for shmoop west to buy

06:28

A call option or really a future on an eighty

06:31

dollars a barrel of oil contract for one year that

06:35

is for eight bucks shmoop west vice the right two

06:39

then pay eighty dollars a barrel for fuel all in

06:43

cost Then would be eighty eight bucks a barrel if

06:46

you know a fuel prices really spiked into the hundreds

06:48

So shmoop west pays the kindly loving derivatives trader at

06:51

goldman sachs five million times eight bucks or forty million

06:55

dollars for this margin life insurance And remember that you

06:58

know today oil in this example sixty bucks a barrel

07:01

of oil would have to go up a lot in

07:03

price to execute this call option but eighty eight bucks

07:07

all in cost per barrel Shmoop west is still a

07:09

profitable airline And remember that in this transaction shmoop west

07:14

has hedged on ly half of its oil needs for

07:16

next year at five million barrels right they used him

07:20

If oil goes crazy say goes to one hundred fifty

07:22

dollars a barrel Well calf of shmoop west fuel needs

07:25

are naked Yeah fully exposed Nothing hides there That is

07:29

shmoop west still has to buy then five million more

07:32

Barrels at market prices of fuel that year A tte

07:34

that time they can do the same exercise paying for

07:37

call options which give them the right to buy that

07:39

fuel of say a hundred bucks a barrel and that

07:42

higher strike price would likely be a lot cheaper than

07:45

eighty dollars Strike price memory paid eight bucks for that

07:48

eighty dollars because in order for that call option contract

07:51

to execute oil prices would have to go up from

07:53

sixty bucks a barrel today Toe well over one hundred

07:56

during the life of that call option contract Could it

07:59

happen Yes likely to happen unless so At sixty bucks

08:02

a barrel shmoop west has an eighteen percent operating margin

08:05

really high for an airline historically at eighty eight bucks

08:08

a barrel the wily financial manager who took this course

08:11

knows that you have to include the cost of the

08:13

hedge as it is inextricably bound now to the cost

08:17

of the fuel inventory So now shmoop west has eight

08:20

ten percent operating margin or something like that because they

08:23

paid so much for hedge is still not a bad

08:25

margin for an airline The key thing you need to

08:27

protect against is negative margin I eat that you ignored

08:31

the fact that the very volatile price fuel expense was

08:34

a key part of your cost structure And if that

08:37

bomb really did go off somewhere in the middle east

08:40

well then at one hundred fifty bucks a barrel could

08:42

shmoop west still keep flying profitably Well it's your job

08:46

to be sure that they can So what happens if

08:48

the price of oil never goes above eighty bucks a

08:50

barrel in the next year Well the gallant goldman sachs

08:53

then just made forty million dollars for a whole lot

08:56

of not working much The contracts expire when they expire

08:59

and the trader at goldman has almost one hundred percent

09:02

profit on the hedge that she sold the nervous nellies

09:05

here It's from up west airlines Nice work if you

09:07

can get it in a whole lot less stressful than

09:10

flying a fleet of jetliners that are you know low 00:09:13.069 --> [endTime] on

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