Running a business can be difficult enough, without also having to track and prioritize your company’s financial metrics. While you may have a CPA or a bookkeeper tracking these things, it is important to understand which metrics are the most important, so you have a clear idea of how the business is performing from a financial perspective. This can help you to manage your growth, or if you’re ready, create an exit plan and prepare to sell your business. Here are a few key metrics that you can start tracking to make sure your business is financially healthy and building value.
Net income is a commonly known term, but it is the basis for many other metrics. It is essentially a business’s gross income minus the cost of doing business. Your business could have millions of dollars in gross revenue, but it will be far from profitable if expenses are higher. Some business owners mix personal expenses with business expenses to lower their net income and thereby lower their tax liability. Doing this will reduce the value of your business and make it more difficult to sell, so do not utilize this strategy if you plan on exiting your business in the next few years.
Profit Margin Ratios
When tracking profit, it’s important to know the difference between gross profit margin and net profit margin. Gross profit margin measures the percentage of revenue left after deducting the cost of goods sold. The cost of goods sold refers to the direct cost of production, and does not include operating expenses, interest, or taxes. This number should be above 50%.
Gross Profit Margin = (Sales – Cost of Goods Sold) / Sales
Net profit margin goes a step further and measures the percentage of revenue and other income left after subtracting all business expenses. These expenses include the cost of goods sold, operating expenses, interest, and taxes. A healthy net profit margin is 10%, while 5% is considered low, and 20% is high.
Net Profit Margin = Net Income / Sales
Net Working Capital
Net working capital is a measure of a company’s operational efficiency and short-term financial health. It is calculated by subtracting current liabilities from current assets. Current assets include things like cash, accounts receivable, unpaid customer bills and inventories. Current liabilities include things like accounts payable and debt. A business with positive net working capital has the potential to invest and grow. Conversely, if a company’s current assets do not outweigh its current liabilities, it is an indication that it may have trouble growing or paying back creditors.
If you plan to sell your business, you should find a way to increase your net working capital by paying off debt and making sure there is enough to run the business. Depending on the size of the deal, and the valuation method used, net working capital may or may not affect the asking price. The type of buyer may also affect the importance of it.
Cash flow is the movement of money in and out of a company. Inflow is the term used to describe money coming in and outflow refers to money going out. There are three types of cash flow, based on the money’s source. They are operating cash flow, cash flow from investing and cash flow from financing.
Operating cash flow is usually the first section on a cash flow statement and is the cash flow from operating activities. It is the inflow and outflow resulting from everyday activities such as selling products or services, buying inventory, paying suppliers, paying employees, paying taxes or paying operating expenses.
Cash flow from investment activities is the amount of cash flowing in and out of the business due to investments, such as buying or selling assets and securities and capital expenditures. The CFI metric is used to determine whether a company is set up for long-term growth. For example, a company might be generating negative cash flow by purchasing assets, but these investments could lead to greater cash flow down the road. Investment activities can help potential buyers and investors understand your company’s financial health.
Cash flow from financing has to do with the money generated or spent on financing activities. It measures the movement of cash between a company’s owners, investors and creditors and deals with the debt and equity of a company, as well as dividends paid to investors. When a business issues bonds, sells stock, or takes out loans to raise cash, it appears in this section of a cash flow statement.
Accounts Receivable / Payable
All businesses need a system of tracking payments from customers as well as payments to vendors, suppliers, and anyone else they owe money to. Payables and receivables go hand in hand and are critical parts of cash flow management.
Accounts receivable track what your customers owe you and ensure there is enough money coming into the business to handle its expenses. Companies with a lot of outstanding customer debt can eventually run into difficulty with paying their bills if they don’t fix their receivables. Most businesses use the accounts receivable turnover ratio to measure the health of their receivables. It determines how quickly your company can collect from its customers.
Accounts Receivable Turnover Ratio = Sales / Total Accounts Receivable
Accounts payable are the money a business owes to vendors and suppliers over a certain period of time. They are an important part of a balance sheet and can tell you if you are spending too much money or relying too much on credit. Tracking your payables can help give you important insight into your business and provide you with the information you need to help reduce your expenses.
Quick ratio is a type of liquidity ratio that measures a business’s ability to quickly pay off debts. If a company’s debt far outweighs its “quick” assets, it may not be financially strong enough to attract investors. The ratio uses only highly liquid assets, such as cash, market securities and accounts receivable. Other items, such as inventory, that cannot be quickly converted to cash are not included in the calculation.
Quick Ratio = Quick Assets – Current Liabilities
Average Customer Acquisition Cost
Customer acquisition cost (CAC) is a metric that measures how much it costs to earn a new customer over a specified period of time. This can vary greatly depending on the industry, but it is very important because it tells business owners how much money they need to expand their customer base without sacrificing profit. The less it costs to earn new business, the wider the profit margin. CAC is calculated by dividing the total cost of sales and marketing by the number of new customers acquired over that same period.
Customer Acquisition Cost = Cost of Sales & Marketing / New Customers Acquired
A business’s churn rate is the rate at which it loses customers. Losing customers is never ideal and some businesses try to compensate for this by putting more money towards customer acquisition. While this might seem like a simple solution, it costs money to bring in new customers and it is much more profitable to keep existing customers happy. A high churn rate affects the other financial metrics on this list because it becomes difficult to maintain consistent growth when customers keep leaving. Without consistent growth, the value of your business will be adversely affected. Like CAC, an average churn rate is dependent on the industry. It can be calculated by dividing the number of customers you have lost by the total number of customers you have for a specific time. If your churn rate is too high, you need to start focusing your efforts on retention.
Churn Rate = Number of Customers Churned / Total Number of Customers
Seasonality is an important performance measure for many businesses in Southwest Florida since the area is affected by high and low seasons. It is the measure of how a period of the year affects financial performance. Companies that understand the seasonality of their business can accurately predict and time inventory management, staffing and make other decisions that could directly reduce costs and increase revenue.
Since a lot of financial data is affected by high and low seasons, seasonality can be adjusted for to give more accurate relative comparisons between time periods. This can be done by using the seasonally adjusted annual rate (SAAR). To calculate this, you would first need to get the seasonality factor, which is revenue for a specific month divided by the average monthly revenue for the year.
Seasonality Factor = Revenue for One Month / Average Monthly Revenue
One the seasonality factor is calculated, SAAR can be calculated by taking the unadjusted monthly estimate, dividing by the seasonality factor, and multiplying by 12. It can also be calculated using quarterly estimates as opposed to monthly, and then multiplying by 4.
SAAR = (Unadjusted Monthly Estimate / Seasonality Factor) x 12
With the complexity of financial metrics, it can be very difficult to determine if your business is profitable, or at least breaking even. These metrics are a good start for being able to accurately gauge your company’s performance or growth. This can help you to re-evaluate how your business spends or invests its money, how you can grow your business faster and how close you are to being able to list it for sale.
If you’re thinking about exiting your business in the next few years and need to get a handle on your finances, consider giving Corporate Investment Business Brokers (CIBB) a call. We work with business owners in Sarasota, Fort Myers and Naples to help prepare to sell their businesses successfully. While we only get paid if a client’s business sells, we make our advisory services available years in advance. This is so you can properly strategize for your eventual exit. Contact us to get a free, no-obligation business valuation estimate and consultation. Knowing what your business is worth is the first step in improving its value.
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