What Every Business Owner Should Understand About Financials Part 2 of 4

Once you understand your financial statements, the next step is to know which numbers matter most to decision making and business performance. Not all metrics are created equal; some metrics are diagnostic/historic, others are KPIs that drive growth. Some Income Statement (P&L) numbers feed directly into the ActionCOACH 6-Ways (6Ws) concept. In this blog I will note the source of each of the metrics presented.

Gross Margin (from P&L and part of 6Ws factor #6)

Your gross margin is the percentage of revenue left after direct costs (COGS). In other words, it is the percentage of revenue of your Gross Profit (Gross Profit = Revenue – COGS). COGS expenses and Gross Profit numbers are sometimes referred to as the “above the line” numbers. Your direct costs are the expenses that are directly incurred to offer your product or service to your customers. COGS expenses vary with your production activities, as you deliver more products or services, your COGS expenses will increase. However, your COGS percentage of revenue should remain more or less constant. COGS tells you how efficiently you deliver your product or service.

Small increases in gross margin create exponential improvements in profit.

Operating Expenses (from P&L and part of 6Ws factor #6)

The Operating Expenses are often referred to as the “below the line” expenses. These expenses are not directly related to production of your products or services. The percentage of these expenses must be less than your company’s the Gross Margin or your company will not have a profit. Some operating expenses, such as rent, or insurance are constant. There are some operating expenses such as electricity or water that vary but are not directly related to production. Reducing operating expenses without hurting capability is powerful, but cutting too deeply harms growth.

Break-Even Point (from P&L)

Your financial Break-Even Point is where the total revenue of your organization is equal to the total variable expense (COGS) plus total operating expense. Once revenue exceeds the Break-Even Point, every additional dollar becomes a dollar of profit.

Another measure of Break-Even is measurement of a company’s activity Break-Even Point. Activity Break-Even is defined as the point where a count of revenue producing activities will produce enough revenue to exceed the financial Break-Even Point. For example, restaurant owners know how many guests (covers) they need every day to exceed their financial Break-Even Point.

Key Ratios to Watch

• Current ratio / quick ratio – (Balance Sheet) Current Ratio = Current Assets ÷ Current Liabilities. This ratio measures your ability to pay your bills. Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities. Quick Ratio excludes current assets that cannot be sold quickly to raise cash to pay current bills. Both ratios should be above 1, preferably above 1.5 to 2.0.

• Accounts receivable days – (Accounts Receivable Aging) Measures the average days it takes your company to collect payment for invoices.
• Accounts payable days – (Accounts Payable Aging) Measures the average days it takes your company to pay its bills.
• Inventory Turnover Ratio – (P&L and Balance Sheet) This ratio measures how fast the funds tied up in your company’s inventory are used within a given period of time. Inventory Turnover Ratio = COGS / Average Inventory. If this ration is large, it indicates that your inventory may be inadequate to properly meet customer demand in a timely manner. Conversely, a small inventory turnover ratio may indicate that your inventory is larger than it needs to be.
• Debt-to-Equity – (Balance Sheet) This ratio measures a company’s financial health. Debt-to-Equity = Total Liabilities / Shareholder Equity. A debt-to-equity (D/E) ratio shows how much debt a company uses versus equity to fund assets; a high ratio (>2.0)signals higher risk (more debt) but potential growth, while a low ratio (<1.0) suggests lower risk (more equity) but possibly slower growth, with <1.0 generally healthy, but the ideal ratio varies significantly by industry.

Takeaway

You cannot influence results that you do not measure. Profit comes from knowing which numbers drive success and acting on them consistently.