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Simple arithmetic can offer some effective regular exercises.
By Richard Ensman
If you’re not an accountant or a budget analyst, you probably don’t want to spend long hours hunched over your general ledger or detailed statistical reports. But you do still want to get a quick fix on the financial health of your enterprise.
There are a variety of common measures you can use to track business success and performance, and most can be calculated using simple arithmetic. Listed here are some easily computable measures you can use anytime to keep tabs on the fiscal well-being of your business. Sometimes a deeper analysis is indicated, probably from an accountant or financial advisor, but tracking these factors over time can help show areas that need work.
What’s my business worth? One of the simplest measures of business success, ‘worth’ or ‘equity’ is simply the value of all your assets less the costs of all your liabilities: Equity = Assets – Liabilities. Asset and liability figures are usually shown on interim balance sheets. If your equity is growing from month to month, or quarter to quarter, you probably have a solid business, with growth potential in the future. (For an in-depth answer to this question, read “Business valuation basics” from the October issue.)
Is my profit high enough? Divide your gross profit by your total expense, obtained from your interim financial statements: Profit Ratio = Gross Profit/Total Expense. This equation helps measure the relationship between your profit and your break-even point. A profit ratio of 100 can mean you’re only clearing expenses. A high profit ratio, for example 125 or 130, is very healthy, especially if it’s rising over time.
Am I carrying too much inventory? Too much inventory ties up valuable working capital. Too little inventory, of course, can be equally problematic since it might be insufficient to meet customer needs. To monitor inventory levels, calculate your inventory turnover from time to time. Simply divide the value of your average inventory into your cost of goods for a given period: Turnover = Cost of Goods for Period/Average Inventory for Period. Monitor this figure over time. Lagging turnover is a sign that you’re carrying too much inventory.
Is my business liquid enough? Take a look at your liquidity ratio: your current assets (including cash and other assets that can be readily converted to cash) divided by your current liabilities: Liquidity Ratio = Current Assets/Current Liabilities. The lower the ratio, the less liquid your business, and the greater the potential for cash flow problems. Be wary of high ratios also: they could indicate that your assets aren’t working for you.
How’s my pace of growth? Examine some comparative figures, for a period of at least a few years. If you’re trying to examine growth in gross income, subtract your income from the last period from your income for the current period, and divide the resulting figure by the last period’s income: Growth Rate = Current Yr. Income – Last Yr. Income/Last Yr. Income. By using the same equation for each of the last three or four years, you can determine your annual growth rate and watch for trends.
What’s my return on investment? You (and probably others) have put assets into the business. How are those assets working today? To find out, divide your current profit by the total assets on hand: ROI = Profit/Assets.
Are my prospecting efforts working? If you use direct response advertising, coupons or targeted sales promotions, you can calculate your success rate in two different ways. First, to obtain the actual response rate, divide the number of returns by the prospect universe: Response Rate = No. Returns/No. Prospects. Second, to obtain a measure of the promotion’s financial success, divide the total dollars earned through the promotion by the prospect universe: Response per Prospect = Total Earnings/No. Prospects. This will give you the average dollars earned through each prospect, as well as the return on investment in the promotion.
Are my customers buying more or less than they used to? Simply calculate your net sales per customer for various periods, every quarter for the last two years, for example: Sales per Customer = Total Net Sales/No. Customers.
Am I selling enough product? If you’re running a retail operation, you may wish to calculate your sales per employee, or your sales per square foot. For example: Sales per Employee = Total Net Sales/No. Employees. If you prefer to look at the relationship between sales and retail space: Sales per Square Foot = Total Net Sales/No. Square Feet.
How long does it take for customers to pay? This is an important, even critical, question if you sell on credit. Divide your total accounts receivable by your average daily sales (to calculate your average daily sales, simply take your annual sales and divide by 365): Payment Interval = Accounts Receivable/Average Daily Sales. Run this equation every month, or every quarter, and monitor the results carefully. If the payment interval increases, it’s a sign that your customers are facing more economic pressures or that your collection practices might be lacking—or both.
How do my bad debts stack up? Add all your bad debts, write-offs and waivers, and divide them by your net sales: Bad Debt Rate = Total Write-offs/Net Sales. Increasing bad debts are a sign of trouble, both for your customers and your business, and may call for tougher collection practices or tighter credit.
Does my product still meet customer needs? One way to answer this question is to examine the number or percentage of credits issued to customers, such as credits due to return of merchandise, as well as good will and customer service allowances. Use this equation: Return and Allowance Ratio = Total Credits/Gross Sales. This ratio is only one measure of your ability to meet customer needs; surveys, customer anecdotes and product line analyses can help outline the big picture.
Is employee turnover increasing or decreasing? Divide the number of terminated employees by the total workforce for a given period of time, then complete the same equation for the last two or three periods: Turnover Rate = No. Terminated Employees/Total No. Employees. For smaller businesses, of course, employee turnover is hard to miss—and often hard to accommodate. For any business, high employee turnover is a sign that polices, practices and possibly salaries need adjustment.
As a general rule, the importance of talking to customers—and employees—cannot be overstated. The information you glean from these conversations tells you volumes about the vitality of your business. Nothing, however, substitutes for statistical measurements like those presented here. Used regularly, they can help you gauge the strength of your business, monitor potential trouble spots, and assure a healthier ROI.