Each business is unique. This is especially true with small businesses, many of which have developed their own special processes or methods of doing things. However, there are some things that all businesses have in common. They all have something to sell with the intent of making a reasonable profit. They all need to purchase materials or inventory and convert them into their finished product, ready to sell at a competitive price. They need customers to purchase their products. They need to make payments to their vendors, send invoices and collect from their customers (because, don’t forget, a sale isn’t really a sale until you collect on that invoice!). And, above all, they need to generate economic value for the owner. So the question is, how do small business owners know that all this is happening the way it should?
Most small business owners are familiar with the basic set of financial statements… the income statement, balance sheet, statement of cash flows…and using these statements to help understand some of their business’ more straightforward performance indicators.
- Did my revenue grow vs a prior period?
- Is my business profitable?
- What is the gross margin on what I’ve sold?
- How much do I owe the bank?
- Did the business generate sufficient cash, and how much cash do I have?
In some cases, this level of review of the business’ performance is appropriate. However, in cases where the owners feel the business should be performing better, or when they have set aggressive growth goals (does either sound familiar?), there is a need to report and analyze the business’ performance more broadly and deeply.
There are countless measurements, reports and ratios out there. We’ve come across books with literally hundreds of ratios to help analyze a business. So performance measurement can be an intimidating element of running a business…and, too often, an element that owners are reluctant to engage in, if not ignore altogether. Trusted business partners and advisors can help small business owners overcome this apprehension by guiding them towards an appropriately-chosen and properly-scoped suite of performance measurements and ratios, based on the organization’s characteristics. Choosing the correct metrics is important. For an easy example, consider inventory performance metrics. These types of metrics are probably critical to manufacturers, distributors and retailers…businesses that rely on inventory…but are meaningless to most service providers that carry little or no inventory at all.
The key to getting started is accurate data, and since that can be a topic onto itself, let’s assume we’re starting with good reports. Reference was made earlier to some of the more basic measurements, like percentage of revenue growth, gross profit percentage, net profit percentage…certainly relevant to most, if not all, businesses. From here though, the selection and scoping of metrics and ratios can take many different paths. Without trying to prescribe the correct measurements, there are some concepts and approaches to keep in mind when putting this together:
1.) What to measure – Which ratios should I be using?
Which financial statement or performance items should be measured? A good tool to begin with to help identify the right items is a Common-Size Financial Statement, which expresses each line item as a % of a total. On the income statement, line items are shown as a % of total sales. On the balance sheet, line items are shown as a % of total assets. Common-size financials are very helpful in conducting comparisons across time periods, as well as providing directional guidance towards other metrics and ratios that should be examined based on their relative importance to the company. Below are some measurements, and their definitions, that are relevant to most businesses and provide a good starting point to understand the business’s performance and current state. Please note that here we simply define these metrics. In a later blog, we will discuss more deeply the theory and meaning of these metrics (i.e. is a bigger number better?), variations in calculations and how to relate them to your business’ performance and operations.
- Gross Profit %: = (total revenue – cost of sales) / total revenue
- Operating Profit %: = (gross profit – operating expenses) / total revenue
- Net Profit %: = net income / total revenue
- EBITDA: = earnings before interest, taxes, depreciation and amortization
- Return on Investment (ROI): = net income / (debt + owner’s equity)
- Return on Total Assets (ROTA): = net income / total assets
- Total Liabilities to Total Assets: = total liabilities / total assets
- Total Liabilities to Tangible Net Worth: = total liabilities / ( owner’s equity – intangible assets)
- Days Sales Outstanding (DSO): = accounts receivable / average daily sales
These numbers, in a vacuum, will tell you something about your company, but may not provide all the input you desire. There are a number of comparisons that make these relevant:
- How do my numbers compare to the industry standard?
Sometimes this is a difficult comparison, because although industry numbers are available for many standard measures in lots of different industries, you may only find them for large publicly held companies in your industry. Your numbers might be totally different from theirs, which doesn’t make them wrong or bad. So, only use these as a rough guideline, not as a benchmark to measure yourself against.
- How are my numbers trending?
This is critically important, because it will tell you if the performance of your company is improving or not. Have the changes you made (or are making) in how you are running your company affected these measures? Changes to some of these numbers, especially balance sheet measures, will change slowly over time – but those changes reflect your company’s financial strength and/or point to impending problems that you might face down the road.
- How are my numbers trending?
- What are your bank’s benchmarks?
Certainly don’t ignore how your bank measures performance. These may be in terms of covenant calculations, or might be in their loan analysis section, where they look at certain measures to determine if they are going to loan money or at what interest rate. Many banks use different benchmarks. Don’t be afraid to ask your banker what their guideline is for Leverage (Total Liabilities to Total Assets) or Tangible Net Worth, or Inventory Turnover, or DSO.
2.) The devil is in the details:
Your financial reports will always consist of two reports – Balance Sheet and Income Statement, and probably a third – Statement of Cash Flows. But these are numbers in summary. They provide a look at the overall performance or condition of the company. You should also be looking at subsidiary reports and other printouts from your computerized accounting system that provide a deeper, more detailed look into specific performance areas of your company…
- Revenues, costs and margins by product line
- Inventory turnover – how fast you are selling your products
- Accounts receivable aging
- Accounts payable aging
- Expenses by department
- Overhead allocations
- Payroll detail
- Comparisons to budget, or the same month last year
- 12 month rolling results
When properly developed, these additional sources of information can be used to create effective dashboards that will allow quick and easy analysis of key performance indicators (KPI’s) and guide business owners to those that are critical for the owner to be able to judge company performance. Examples include:
- How quickly are orders shipped (sales turnaround)?
- What are the Inventory turns?
- You can even measure front office performance by measuring phone usage – the number of times a call is put on hold rather than transferred, the number of incomplete calls (the customer hung up),
- Web site orders that are left incomplete (the customer left the site with product in the shopping c)
Note that not all dashboard items are financial. The key consideration is what does the owner/entrepreneur want/need to know about his business to make it run better, smoother, more profitably?
3.) Time periods and frequency:
Understanding the period being measured is critical, particularly when conducting comparisons. Frequency is also important…some dashboard items may call for daily review, others monthly, quarterly or annually. There are also rolling reports that can be used to properly capture and illustrate the effects of an organization’s business cycle, or eliminate the business cycle from the analysis. For example, a rolling 12 month comparison of the income statement allows you to see year over year changes, taking into account your business cycle, since the 12 month period includes all aspects of the normal change in your business from month to month. This makes a comparison to last year’s results even more relevant.
4.) Consistency is King:
When measuring performance or calculating ratios, it is important to use the same methodology each time. Consistency in preparation is a requirement for effective comparisons and meaningful use of the measurements. Revisions to reports, calculations and formulas are not uncommon. However, be sure to go back and understand the changes in prior reporting periods to ensure an “apples to apples” comparison. Or, at a minimum, document the impact that a change in methodology has on a particular measurement.
5.) What are you comparing to?
The real value of most metrics and ratios is understanding how, when consistently prepared, they move and trend over a period of time, and how they compare to plans or expectations. Identifying trends and variances are two absolutely critical pieces to problem solving, allowing you to identify opportunities and guide business decision making. These types of comparisons will often uncover irregular or erroneous postings, incorrect accruals, and other items that, when unchecked, will obscure the actual performance of the company, which could potentially lead to bad, or delayed decisions.
The above concepts should be part of a holistic plan to help you get a firm handle on your company’s performance, and establish appropriate actions and plans to drive growth and improved results.
CFO Simplified is your strategic financial partner to drive growth, profitability and value into your business. For more information and examples of how CFO Simplified has helped clients achieve these objectives, please review the services offered and case studies available on our website.