« Back

Financial Knowledge is Power

April 25, 2016 by Andrew Schwarz


Monitoring financial performance indicators is key to business success and achieving business profitability.  Many small business owners find it difficult to understand and monitor the financial side of their business.

 

You could not successfully drive your car any significant distance without knowing some key performance indicators about how your car is operating.  These include such things as how much fuel do you have, what speed are you travelling at, what is your engine temperature, what is the oil pressure.  Without these key indicators there is a high chance that something will go wrong and you will not achieve your goal of getting to your destination by a certain time.

 

It is the same in business without having a system to collect data about how your business is travelling there is no way of monitoring how you are tracking towards your goals both strategic and financial.  Without this knowledge you cannot improve performance.

 

For many small business owners, the profit and loss and balance sheet that they print out from their management accounts or the one prepared by their accountant at year end is just a set of numbers with no real meaning, aside from the figure at the bottom of the profit and loss report.

 

In this short article I will not cover a detailed analysis of the financial statements and what they mean rather I want to highlight three simple strategies that business owners can use monitor performance and gain knowledge about what is happening within their business so that they can make decisions.

 

The three strategies that I suggest business owners do and review on a monthly basis are:

 

1.     Have a budget and monitor performance to budget;

2.     Monitor performance to historical; and

3.     Conduct some simple ratio analysis to delve a little deeper.

 

1.     Have a budget and monitor performance

 

You wouldn’t build a house without first having a set of plans, similarly you are unlikely to undertake that long road trip without first reviewing a map and planning where you are going.  A budget is the financial road map of your business.  The budget when aligned with your strategy sets your goals and expectations for the coming year in a financial context.

 

You can set a budget for all aspects of your business, but I suggest you start with a profit and loss budget.  As this will give you a goal to aim for with regard to sales, costs and profit.

 

In setting your budget I suggest you first look at how your business has performed historically, say over the last 3 or 5 years.  What sales growth have you typically experienced, what have the costs been compared to the revenue achieved and how have the costs changed over time.  Once you have conducted some historical review to determine the key trends and relationships between sales and costs I suggest you then overlay this information with your strategy and economic outlook.

 

Once you have considered all these aspects you can then set your budget listing your likely revenue, costs and profit for the year ahead.  You should then break this budget up into 12 monthly forecasts having regard to any seasonality in your business.

 

Now you have a basis to monitor performance and assess how your business is travelling each month against your plan.  Then each month you can compare actual results to budgeted results and assess the reasons for any variances.  This enables you to make changes during the year to continually strive to steer your business towards budget and profit.

 

2.     Monitor performance to historical results

 

History contains valuable information about how things may play out in the future.  We have all heard the saying ‘history repeats itself’, well in a business this is very true as history will tell us a lot about our business and how it typically performs. That is why it is useful information when setting your budget.

 

It is also useful information to monitor business performance against say the last three years.  This will give you a picture as to how your business is travelling against how it has typically travelled in the past.  In particular it enables you to identify key variances in trends and identify if something is amiss.

 

Some examples include:

 

·       How your sales typically perform, are there months in the year when sales are higher than others

·       Are costs in line with what they have been in the past or in line with the level of sales previously generated

·       Is your current sales growth in line with historical

 

Comparing current to historical will assist you in understanding how your business is travelling and will enable you to make the adjustments needed to achieve the budget and ultimately profitability.

 

3.     Conduct some simple ratio analysis

 

There are a number of financial rations that businesses can use to monitor and assess performance.  Detailed below are some rations that I believe all business owners should be monitoring regularly as they have a significant impact on profitability.

 

 

 

 

 

a.     Gross Profit Margin

 

Formula = (Revenue – COGS) / Sales

 

This tells you your gross profit margin, which is the % of revenue left over after covering the direct costs required to earn that revenue.  It is the amount of money available to cover overhead and profit.  The higher the gross margin the greater the health of your business.

 

b.     Break Even Sales Point

 

Formula = Fixed Costs / (Revenue – Variable Costs)

 

Break even analysis is a management tool to tell you the level of revenue or sales volume you need to achieve to cover all your costs or break even.  This is particularly useful when applied to individual product lines.

 

c.      Revenue Growth

 

Formula = [(Current year revenue – Last year revenue) / (Last year Revenue)] x 100

 

This tells you your percentage of revenue growth achieved.  This can be applied weekly, monthly or yearly.

 

d.     COGS Percentage

 

Formula = (COGS / Revenue) x 100

 

This the cost incurred in getting your product sold.  A small reduction in the COGS percentage significantly improve revenue.

 

e.     Overhead Percentage

 

Formula = (Operating expenses / Revenue) x 100

 

This tells you the relationship of your overheads to sales.  It shows you if you are making enough profit on your revenue building activities.

 

f.       Days Receivable

 

Formula = (Accounts receivable / Revenue) x 365

 

This is the number of days on average customers are taking to pay you. If you can reduce the number of days it will significantly improve your cashflow

 

 

 

g.      Days Payable

 

Formula – (Accounts payable / Revenue) x 365

 

This means the number of days you pay suppliers.  Once again if you can stretch this out you will improve your cashflow.  However, if this number is getting bigger and you haven’t consciously made the decision to stretch creditors it could be a warning sign of problems in your business and that you are short of cash.

 

h.     Days Inventory

 

Formula = (Accounts payable / COGS) x 365

 

This is the number of days on average that stock is sitting in your warehouse.  The longer stock sits around in our warehouse the more cash you have sitting idle. If you can reduce stock days it will improve your cashflow and working capital.

 

i.       Working Capital

 

Formula = Current Assets / Current Liabilities

 

This is a measure of the liquidity in your business.  It provides an assessment of your ability to trade the business through the ability to purchase stock, give customers credit, and pay the business liabilities as and when they fall due.  As a rule of thumb you should aim for a ratio of 2:1, which is twice the amount of assets to liabilities.

 

As noted above there are a number of ratios for financial analysis, however these are some of the key ones in my opinion to assess business performance.

 

AS Advisory is a boutique corporate advisory firm focussed on solving business problems in the SME sector. If you would like assistance with business planning or financial performance or more specific advice about your situation email me directly at

andrew@asadvisory.com.au or visit our website www.asadvisory.com.au

© Andrew Schwarz all rights reserved

 

 



Tags: Corporate Advisory

Comments

Add Comment