Your quarterly financial statements are in, and the results are disappointing. Sales are up, but profit is down.
Meanwhile you seem to be running low on cash. The income statement says you are making a profit, but it never seems to materialize in your bank account. The unpaid bills are starting to pile up, and you’re not sure if you can afford to pay them.
Sound familiar?
With the Money Mastery Roadmap, GT Business Advisory helps entrepreneurs become more focused and effective business owners. My last post described the first step, the 3-Point Inspection. If the situation above applies to you, then the 3-Point Inspection will come up with some negative results. Now what?
Today’s topic is step two: Tracking Performance. It’s time to dig a little deeper, and really understand your numbers and what they mean.
First, let me suggest that you check out a terrific book on the subject of tracking performance: The 60-Minute CFO, by David A. Duryee. Honestly, if you close this window right now and read that book instead, you’ll be miles ahead of where you started.
Key Performance Indicators
But let’s assume you’re still with me. Duryee’s book boils down the task of diagnosing and monitoring business financial performance into a short list of key performance indicators (KPIs) that every business owner should track.
Don’t let the acronym scare you. KPIs are easy to understand. They are numbers that you can calculate from items already on your financial statements, which provide more insight into the health of your business.
Since we’re talking about a roadmap, let’s extend the automotive analogy. Miles per gallon is a KPI that any car owner will recognize. It is a ratio of two numbers — distance travelled and the amount of gas used — and it measures how efficiently your car consumes fuel.
Say you start a journey with a full 16-gallon tank of gas in a mid-size sedan. Your odometer tells you that you have travelled 200 miles. Your gas gauge shows you have used half a tank of gas, or 8 gallons. 200 ¸ 8 = 25, so you got 25 miles per gallon. That’s your KPI for this journey: 25 mpg.
Now, let’s assume you make a habit of measuring this KPI, and over time you notice it going down. One month you calculate 24 mpg. The next month it’s 23 mpg. Two months later it’s all the way down to 20 mpg. Something seems to be degrading your car’s performance. Having measured that KPI over time, you can see a clear trend. And now you know it’s time to take it to the shop and get it fixed.
Business KPIs function in the same way. You pick a few metrics you want to monitor. You measure them over time. And if you see declining trends, you know it’s time to take action.
The importance of benchmarking
OK, so far, so good. Your car gets 25 mpg. But is that good or bad?
To know that, you need a benchmark – a number to compare yourself against.
So, you consult the internet, and come across a recent Reuters article which says that the average fuel efficiency of new cars and trucks in the US is 24.7 mpg.1 So, by that yardstick, you got a C on your report card, and match the national average.
But wait, you have a mid-size sedan. Should you really compare yourself to an average that includes gas-guzzling SUVs and pickup trucks? Probably not. So, you do a little more research, and learn that according to Autotrader, the 8 most efficient mid-size sedans range from 31 to 47 mpg.2
So now you have a different point of view. If you compare yourself to the national average for a generic vehicle, you’re doing fine. But if you compare yourself to the best performers for your kind of car, your 25 mpg kind of stinks.
Benchmarking your business KPIs provides the same kind of clarity. Let’s say your gross margin this year is 55%, an increase over last year’s 53%. Sounds good, right?
But suppose you read in your industry association’s newsletter that your competitors have an average gross margin of 65%. Now you know you have more work to do.
Key KPIs for Your Business
Ok, great. You get the concept of KPIs and the importance of benchmarking. But what should you measure, and where do you find the information you need?
Just as your car’s dashboard provides you the numbers you need to measure miles per gallon, your financial statements – the income statement (aka profit & loss), balance sheet, and statement of cash flows – give you the numbers you need to calculate your KPIs.
Going back to Duryee’s book, there are a handful of KPIs that apply to every business and should be measured and tracked across the board. These include the following:
1. Measures of liquidity, or your ability to pay your debts. The key KPI here is the Current Ratio (current assets divided by current liabilities), which tells you whether you have sufficient working capital to cover your bills and stay afloat.
A good general benchmark for the current ratio is 1.5 to 2.0, meaning that your current assets (cash in the bank, plus accounts receivable and inventory) are 1.5 to 2 times greater than your current liabilities (e.g. credit card debt, accounts payable, taxes payable).
We also like to look at the Cash Ratio (cash in the bank divided by current liabilities). In an extreme case where all of your outstanding invoices were uncollectible and your inventory could not be sold, this KPI tells you whether you could cover your bills with cash currently on hand. It also a good metric to monitor if your customers typically take a long time to pay you, or your business has to carry a large amount of inventory.
You always want this ratio to be above 1.0, meaning you have more in the bank than the amount you owe.
These numbers are found on your balance sheet.
2. Measures of safety, or the likelihood that your business can survive a downturn. The key KPI here is the Debt-to-Equity Ratio (total liabilities divided by total equity) which compares the amount of debt you’ve taken on relative to the underlying value of the business. This number will be of particular interest if you are seeking a bank loan or trying to raise investor capital. You need to be able to show that haven’t taken on more debt than you can handle if your income drops significantly.
A good benchmark for this KPI is 1.0 to 1.5, meaning that debt should be no more than 1.5 times your equity.
These numbers are also found on your balance sheet.
3. Measures of profitability, or your ability to make money. There are plenty of KPIs to consider here, but the key ones are Gross Margin (gross profit divided by total revenue), Operating Margin (operating profit divided by total revenue), and Net Margin (net income divided by total revenue).
Gross margin measures how much money your business generates after covering the direct, unavoidable costs of making sales. It is the key driver of profitability. Operating margin shows how well you are managing your business and keeping overhead costs under control. And net margin is the bottom line: the profit percentage after extra things like non-operating income and interest expenses are taken into account.
There is no one rule of thumb for benchmarking these KPIs. They differ widely by industry, business size, and other factors, so you’ll have to do some research.
These numbers are found on the income statement.
Other KPIs
Beyond the key measures of liquidity, safety, and profitability, there are many other KPIs that can be critically important to some businesses and not to others.
For example, if your company extends a lot of credit to customers in the form of lengthy payment terms on invoices, then monitoring how quickly you are being paid by your customers (a KPI called Days Sales Outstanding) is critically important to managing your cash. But if your customers tend to pay you up front, this KPI won’t mean much to you.
If your business carries a lot of inventory, then measuring how quickly you sell that inventory (a KPI called Inventory Days) be hugely important. If not, then not so much.
As you can see, tracking your business performance is a mix of art and science. You can identify additional KPIs that are meaningful for your business by doing some research on your industry, consulting industry association publications, and talking to others in your field.
In addition, a trusted business advisor can help you analyze your recent numbers and determine which KPIs are the most important for you to track. Your advisor can also create and maintain a KPI dashboard to be updated monthly, so you can keep a close eye on your critical numbers and take action where it’s needed.
So now you know the second step you must take to achieve money mastery in your business. Want some help? Schedule time with us to arrange an initial 3-Point Inspection for just $97. Or just set up time to chat!
2https://www.autotrader.com/car-news/8-most-fuel-efficient-midsize-sedans-228248