Business… It’s a game of numbers, right?
Absolutely! Most people start a business because they’re passionate about a product, whether it’s a digital agency, or a financial planning business, or store manufacturing widgets. And yes, it is important to have a passion for your product.
It’s also important to know your numbers. No matter how much you love creating fun, colourful websites, your business will never survive if you don’t make some money on those websites designs.
“But I’m not a numbers person!” you might say. That’s okay, you don’t have to be an accountant to follow a few important numbers and develop a keen eye for trends.
In this article, we’ll delve into five important numbers that every business owner should keep an eye on.
1. Accounts Receivable
If you sell anything on credit, meaning you allow your customers some time to pay after they receive their product or service, accounts receivable (AR) is a very important number. You can get a ton of information on how your business is performing by analyzing your average AR.
AR is an asset on your business balance sheet and it represents the money customers owe you on unpaid invoices. All AR levels are industry-relevant, meaning different industries will have different “norms” for how AR should look.
Take a hard look at your historical AR levels on a monthly, quarterly, and annual basis. See how those levels trend. Depending on your business, they may fluctuate up and down with the seasons.
If you see them start to rise uncharacteristically, it’s time to get cracking on some better collection practices. You might also want to renegotiate credit terms with your customers to keep that number from creeping up.
Falling AR could be a sign of successful collection efforts, but it could also indicate that your sales pipeline is drying up. Either way, it’s good to learn those trends and keep a diligent watch on AR levels.
2. Gross and Net Profit Margin
It’s always great to see profits, but to understand how your company is doing, it’s more efficient to take a look at your margins.
Gross Profit Margin (GPM) is calculated as follows: (Gross Revenues – Cost of Goods Sold) / Gross Revenues
This ratio is an important long-term ratio because you can compare it with your businesses historical performance to see how efficient your company is at creating its products. Unlike Gross Profit, which is a dollar figure, this ratio isn’t affected by sales growth.
A company manufacturing widgets might have an average GPM of 15%. This means that after they pay their raw materials suppliers, they have about 15% of their revenues left to pay operating expenses, like utilities, wages, etc.
This number should remain level over time, or in a best-case scenario, improve. If it starts to fall, it means you’ve lost efficiency and you need to take a look at your processes to figure out where the problem lies.
Many companies, like those in service industries, don’t have a Cost of Goods Sold because they don’t make anything.
This is where the Net Profit Margin (NPM) can serve as a better indicator of financial health.
Net Profit Margin is calculated as follows: Net Income / Gross Revenues
NPM tells you how efficiently your company is after operating expenses. Because it’s a ratio rather than a dollar figure, it’s also not affected by sales growth. This number should remain level or improve over time as your company becomes more efficient.
3. Working Capital
Working Capital is a measure of liquidity, or your company’s ability to convert assets into cash quickly. Liquid assets include Cash, Marketable Securities, Accounts Receivable, and Inventory. These items make up Current Assets on your business balance sheet.
Current Assets are offset on the balance sheet by Current Liabilities. These are notes due within the next 12 months. This might include Accounts Payable, Short-Term Notes Payable such as a line of credit with a bank, Income Taxes Payable, and the Current Portion of Long-Term Debt (CPLTD).
Calculate Working Capital with this formula: Current Assets – Current Liabilities
How much working capital you have in your balance sheet depends on the industry, much like AR. But your business should always be able to cover its current liabilities with liquid assets.
Watch this number over time and if you see it starting to fall, it means your company is becoming more leveraged. A little leverage is okay, but too much can quickly spiral out of control.
Inventory includes anything you sell to your customers. Tracking the flow of inventory in and out of your business is important to know how well you’re managing costs and sales.
The Inventory Turnover Ratio (ITR) is a key measure for monitoring inventory. It tells you how many times your business turns its entire inventory over in a given period. You want to see a solid, consistent trend line for ITR over time.
ITR is calculated like this: Cost of Goods Sold (COGS) / Average Inventory
If COGS for the last 12 months was $100,000 and your average inventory amount was $50,000, that means you turned over your inventory twice during that period.
Higher inventory turnover is usually better because it means you’re selling more products faster. Of course, if it spikes up too high, it could mean that you aren’t carrying enough product in stock to satisfy demand. Lower turnover means you might need to bump up your sales methods to move products.
5. Cash Conversion Cycle
The Cash Conversion Cycle (CCC) is a measure of how many days it takes you to convert inventory into cash. It takes into account how long it takes to sell the inventory, collect receivables, and how long you have to make a payment on your bills before you receive a penalty.
In other words, the CCC is an aggregate timeframe for how long it takes your business to go from start to finish in the cash production cycle. The quicker you can produce cash, the better! To calculate CCC, you’ll to gather the following numbers:
> Beginning and ending inventory balances
> Beginning and ending AR balances
> Beginning and ending Accounts Payable (AP) balances
> The number of days in the period (in this article, we’ll use 365 as the number of days in a year)
The following formulas will bring you to CCC:
> Days Inventory Outstanding (DIO) = (Average Inventory / COGS) X 365
> Days Sales Outstanding (DSO) = Average AR / Revenue per Day
> Days Payable Outstanding (DPO) = Average AP / COGS per Day
> CCC = DIO + DSO – DPO
Know Your Numbers, Know Your Business
You might be the most talented nail artist in all of Australia, but if you don’t know your numbers, you don’t know your business. At Cloud CFO, we specialize in helping our customers know their numbers.
Click here to check out the many financial services we offer. We go beyond the numbers and help you reach your goals!