The Margin Improvement Trap

Revenue down, margins up. That should be a good story. Then you follow the cash and it isn't. I pulled apart the financials of a mid-cap company recently, have a read about some of the things I found.

Revenue down 11%. Operating margins up. Sounds like disciplined management, right?

I pulled apart the financials of a mid-cap services group recently. Three years of data. The headline story was clean: revenue fell from $242 million to $168 million, but EBITDA margins improved from around 9.7% to 10.2%. The cost base came down, it was a leaner operation, and it was likely that the board deck probably read well.

Then I looked at the cash. Free cash flow went from $54 million to $8.8 million. That's an 84% collapse. Operating cash flow dropped from $61 million to $15 million. Cash on the balance sheet had almost halved from $52 million down to $34 million. Margins improved while the business generated a fraction of the cash it used to. How? Because margins are ratios. And ratios lie when the denominator is shrinking faster than you think.

When you cut $21 million in costs against a $73 million revenue decline, your margin percentage ticks up. That's mathematically inevitable, but in absolute dollar terms, your operating income dropped from $79 million to $26 million. The business is generating $53 million less profit per year. No percentage improvement changes that. This is the trap that ratios can set, and out of context it's far too easy to fall into.

Margin improvement is reported to shareholders while the actual earnings engine is deteriorating underneath. The percentage becomes a comfort blanket that obscures the trajectory. It gets worse when you follow the cash.

This company's cash conversion efficiency (the proportion of operating cash flow that converts to free cash flow) sat at 59.5%. Reasonable, but not remarkable. But when your OCF has already dropped 76%, that 59.5% is converting a much smaller pool. The $8.8 million in free cash flow wouldn't cover a single meaningful acquisition or a decent technology investment.

Here's what I'd be asking in the boardroom: at what point does "leaner" become "too thin to invest"?

Because the projected revenue trajectory on this business is negative 16.4% annually. If that continues, you're looking at sub-$100 million revenue within three years. At which point your "improved" margin delivers an operating profit that barely covers corporate overheads.

Margins are a useful diagnostic, but they are a terrible strategy metric on their own. The moment a board starts celebrating percentage improvements during a revenue decline, someone needs to stand up and put the absolute numbers on the table. $79 million to $26 million.

That's the number that matters.