Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers."
Businessman Tilman Fertitta reminds us that it might not matter how great a product or service you offer. If you don't keep on top of your financials and "know your numbers," your business may not be financially successful.
So what does it mean to "know your numbers?"
You get to know your numbers by keeping them up to date, understanding what metrics to measure, and making a habit of checking the metrics that measure your business's performance.
Keep Financials Up to Date
Before you can track your business's performance, every financial statement and report needs to be up to date. Every accounting transaction affects at least one financial statement. Therefore, transactions must be entered and accounts must be reconciled in a timely manner. We utilize QuickBooks software for our clients and provide regular training on QuickBooks on how to be more accurate with bookkeeping.
Financial statements provide insight into your business’s performance. The profit and loss statement measures sales, direct cost of those sales (or cost of goods sold), and the operating expenses for a business within a given date range. The balance sheet is the record of the value of assets, liabilities, and owner’s equity at a point in time that is cumulative from the first day of business. Lastly, the statement of cash flows reports fluctuations in cash and the reasons for cash inflows and outflows within a particular date range.
Determine Key Performance Indicators (KPIs)
With current and accurate financial information, you can determine how to measure your business’s performance. One way to track your business’s performance is with a Key Performance Indicator (KPI). A KPI is a value that demonstrates how a company is reaching its key business objectives. KPIs may be financial, operational, or sales/marketing based. We will focus on the financial based KPIs.
Comparison can be one of the most beneficial aspects of these KPIs. Because KPIs use numbers from the financial statements, it's imperative that the financial statements are accurate. The goal is to use the financial statements and KPIs as a consistent standard to measure company performance, value, and to ultimately, make better strategic decisions.
Let’s look at three important KPIs for any business to track: Contribution Margin, Net Profit Margin, and Working Capital.
1. Contribution Margin
It can be easy to focus entirely on the bottom line of your business. However, simply comparing your net income between time periods doesn't explain the whole picture of what's going on in your business. It's important to look at the different components that make up your bottom line.
One of the most important numbers to monitor is the contribution margin of the business.
Contribution Margin = Revenue - Cost of Goods Sold - Direct Labor
Revenue, cost of goods sold, and direct labor typically have the most influence on your net income. Focusing on contribution margin helps you realize the relationship between sales and the direct costs of sales.
There are three ways to improve your contribution margin:
- Increase price
- Decrease cost of goods sold
- You may need to procure your materials from a different source, negotiate a better purchase price, change the materials used in the making your product, or reduce waste.
- Decrease cost of direct labor
- Look for ways to be more efficient and/or manage your workforce more effectively.
You may also evaluate contribution margin as a percent of revenue. Simply take the contribution margin divided by the sales to get the contribution margin percentage. It may be helpful to compare this percentage over several time periods.
Greg Crabtree, author of the book Simple Numbers, Straight Talk, Big Profits: 4 Keys to Unlock Your Business Potential, strongly advocates for contribution margin to be your #1 metric.
2. Net Income Margin
Another way to look at net income is by the percentage of revenue, or net income margin.
Net Income Margin = Net Income / Total Revenue
This will help you to envision how much of sales may possibly become net income later. Look for trends in profitability by reviewing net income margin over months, quarters, and years.
As a general rule of thumb, you may use these benchmarks to evaluate how your business measures up:
- 15% or higher - Excellent net income! You are on the right track.
- 10% - Baseline target net income for a healthy business
- 5% or less - Your business is on life support! Take immediate action to increase net revenue or decrease cost of goods sold or operating expenses.
Feel free to contact us for more industry-specific benchmarks.
In our sample Profit and Loss statement above, the net income margin of almost 21% means the business is definitely staying afloat!
3. Working Capital
While the balance in your bank account can be an important metric, that number alone isn’t sufficient to measure your business success. Consider instead monitoring your working capital.
Working Capital = Current Assets - Current Liabilities
You may find that cash is tied up in inventory. Credit lines and short-term loans may be increasing your bank account balance, instead of profits. This can give a false sense of security.
There are expenses that show up on the profit and loss which aren’t reflected on the statement of cash flows. For example, depreciation and amortization expenses reduce your net income. However, there isn’t an exact match of cash leaving the company each month; the asset may have been paid for at the time of purchase or financed over a different time period than it is depreciated over.
Another consideration is that cash can be affected without being shown on the profit and loss statement. This includes draws or distributions to owners and principal payments on loans. These cash outlays are not expenses, but do affect the amount of cash available to operate the business.
Alan Miltz is a firm believer in "cash is king." He strives to help businesses understand ways to improve their cash flow to drive profit improvements.
Establish a Scorecard or Dashboard
Be sure to establish a scorecard or dashboard that can hold the most important information to regularly monitor. These may include the above KPIs, as well as profitability percentage, total revenue, gross margin, direct labor versus the contribution margin, management labor versus contribution margin, and liquidity capitalization. These metrics will help you to measure up and manage your company to maximize profitability.
Here's a sample scorecard based on the above example:
Need help determining exactly which KPIs make the most sense to monitor for your business? Contact us - we're here to help!
Your financial statements are available to help you to help you understand the condition of your business for continuity or for an eventual sale when you're ready to turn over the helm. Your numbers may be telling you that you're sailing at 7 knots or conversely, that you're underwater and searching for a lifeline.
Remember that understanding your financial state is the first step to getting you back to your real passion of making your business dreams a reality. As Ralph Waldo Emerson said:
Every man's task [his 'great dream' and impassioned life-goal] is his life preserver.”