Profit. The bottom line. This is obviously a key performance measure that all business owners would be familiar with.
But is this the best, or the only way to measure business performance?
Keeping an eye on the bottom line is of course necessary. But when your profit is not what it should be, the number itself doesn’t tell you much. It doesn’t help you determine why you’re falling short.
What can you change to increase profits? Or better still, how do you know there’s an issue before it even impacts on profit?
Highly skilled analysts in the world’s biggest investment banks look at a huge number of business performance measures, with these often broken down and analysed in three categories. Here’s some of the key measures that any business can use to gain insight into their business performance.
Profit of course is the key driver of all businesses. No profit, no business. So it follows that profit is a key business performance measure. But in addition to net profit, we can look at some profit ratios to give us a little more insight. Two key profit measures are:
Gross Profit Margin
Gross Profit Margin provides a view on the high-level profitability of the products and services that you sell. It strips away operating costs, so any variability in those costs does not muddy the waters in understanding if you have a profitable product. This measure may help shed light on whether you’re pricing correctly, whether production costs have been increasing etc.
Gross Profit Margin = Net Sales / Total Sales
Benchmarking this margin against industry averages can provide valuable information about how you stack up against competitors. Its important to benchmark based on your industry, eg a GP Margin of 40% in food manufacturing might be a good target, whereas for a gym, a margin in the area of 70% is more common.
As for all metrics and ratios, there may be variances in how they are calculated, so you do need to be careful when benchmarking to use comparable figures.
Net Profit Margin
Your Net Profit tells you how much you’re making, but it doesn’t give any insight into how much you could be making. By comparing profit to sales, the Net Profit Margin gives you some insight into the costs of your business and indicates whether you’re running a lean business or if there’s scope to cut costs.
Net Profit Margin = Net Profit / Total Sales
Again, this margin is useful for benchmarking your performance against others in your industry. Its also useful to compare this and other margins across your own performance quarterly or yearly.
Efficiency performance measures give some insight into how well you’re using your business assets to create value. This is important, as an inefficient business will struggle over time, and to be honest, it may be better saving your time, stress and effort by investing you’re money in a passive asset to earn your return.
For product businesses, a big investment is often made in inventory / stock. Having money tied up in inventory is wasteful, as it could be employed to earn a return elsewhere. Ideally, you should limit your stock holding and manufacture in more of a just in time methodology. This is obviously critical where you have a product that expires, such as food. The last thing you want is to be throwing product away, or selling at a deep discount just to shift it.
Inventory Days = Inventory x 365 / Cost of Sales
Inventory days tells you, on average, how many days it takes to sell the stock you have on hand. The lower this number the better, although that of course needs to reconciled with your supply chain lead times and the possibility and cost of out of stock situations.
Accounts Receivable Days
Accounts receivable or debtor days measures, on average, the number of days it takes your customers to pay you. This is largely driven by the credit terms you allow your customers, but is also impacted by their payment policies and payment performance.
Accounts Receivable Days = Accounts Receivable x 365 / Sales
Reducing debtor days will improve your cashflow and business efficiency.
Accounts Payable Days
Accounts payable or creditor days measures, on average, the number of days it takes you to pay your suppliers. The more favourable the payment terms that you’ve negotiated, the longer you have to pay and the higher your credit days might be.
Accounts Payable Days = Accounts Payable x 365 / Cost of Sales
Increasing creditor days will improve your cashflow and business efficiency.
Leverage and Solvency
The third grouping of performance metrics looks at the use of leverage in a business, along with the strength of a business in terms of its ability to remain solvent.
Debt to Equity
This metric looks at the amount of debt used to finance a business, versus the amount of equity invested by shareholders. Debt is considered to be much cheaper than equity, particularly in our low interest rate environment. But too much debt can lead to cash flow trouble, this measure provides a quick view on a company’s debt position.
Debt to Equity Ratio = Total Debt / Total Shareholders Equity
There is no right or wrong amount of debt, but a debt to equity ratio in excess of 1 would be considered dangerous in most circumstances.
The Quick Ratio (sometimes called the Acid Test Ratio) measures the ability of a company to pay its short term liabilities with liquid short term assets.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
This measure excludes inventory, in order to focus on and asses the availability of cash and cash-like assets to pay short term liabilities. A quick ratio below 1 could indicate a risky situation where a company relies on inventory and other assets to pay day-to-day bills.
Towards Better Business Performance
Yes, profit is a key performance measure in most businesses. But it does little to inform you why you’re performing well or not.
But with a view on other measures that drive profitability, efficiency and leverage, you can develop more meaningful and nuanced views of your ongoing business performance. And with greater insight, you’re empowered to make changes that will have a real impact on your bottom line.
A word of caution though, these metrics can be indicators of performance and good tools for benchmarking, but they won’t necessarily be relevant to all businesses. There’s also different ways to calculate many of these measures, making benchmarking sometimes difficult. And there are a whole plethora of other measures that may work for you based on your circumstances.
Would you like to better understand and improve your business performance? If so, why not book an obligation-free 20 minute consultation to discuss this topic with our Virtual CFO, Andrew Terlich here.