The Critical Numbers You Need to Know for Business Success (Part 2 of 2)
By: Andrew J.Sherman
Partner, M&A and Corporate Department, Jones Day
JUNE 03, 2014
Key Performance Indicators
Every business has a series of key performance indicators or KPIs. A KPI is a performance measurement tool that you can look at daily, weekly, monthly, quarterly, annually or on a project-by-project or division-by-division basis to help you measure and predict the overall health and efficiency of your company’s operations. The effective use and interpretation of your KPIs can help you do a number of very critical financial management tasks:
• Define and measure the progress you’re making toward your goals
• Make informed decisions as to budgeting and resource allocation
• Avoid being blindsided or surprised by weak results
• Detect fraud, waste or severe inefficiencies
• Give you the comfort you need to sleep at night and to face your lenders or investors with confidence
Remember that as your business grows, you may one day need to raise capital via the equity or debt route, and those sources of capital will want to see these reports and controls in great detail. The sooner you’re capable of producing (and understanding) these reports, the more secure your foundation for growth.
Here are some of the most common key performance indicators that businesses use to monitor the financial health of their businesses:
Sales. Accurate sales figures are the first indicator of business trends. Whether they’re increasing, decreasing or flat-lining, they provide a clear indication of where your business is heading. But they must be monitored in conjunction with bottom-line performance as well. Many small-business owners become too top-line focused and take false comfort in knowing that sales are growing even though margins may be shrinking.
Cash flow forecasts. You should calculate your cash flow forecast on a weekly or monthly basis; more often is better, especially during a growth spurt. The calculation goes like this: cash in the bank plus cash coming in over the next four weeks minus cash going out over the next four weeks. This number will reveal any cash shortfalls over the next four weeks and your ability to pay your bills at the end of the month.
Debtor days outstanding. This is the average number of days it takes for your customers to pay your invoices. The calculation goes like this: accounts receivable/sales multiplied by 365. A decrease is a positive sign, while an increase is an issue, as it will affect your cash flow and your ability to keep your creditors current.
Creditor days outstanding. This is the average number of days it takes you to pay your suppliers. The calculation goes like this: accounts payable/purchases multiplied by 365. This figure needs to be monitored in conjunction with your debtor days, as ideally, you would want the number of creditor days to be equal to or higher than your debtor days. If it’s lower, you need to improve your debt collection, reduce your customer’s credit terms or negotiate better payment terms with your suppliers to avoid cash flow problems. This is one of the critical disconnects that can cripple a small company.
Inventory days or stock turnover. This is the average number of days the inventory you produce or purchase remains in your warehouse or on your shelves before you sell it. The calculation goes like this: inventory/purchases multiplied by 365. The lower the number, the better for your cash flow, which ultimately allows you to grow your business and expand your customer base without straining your resources. Inventory that’s “collecting dust” is costing you money without a return and may be stale, obsolete or have been ordered in excess of demand. You need to carefully monitor what’s moving and what’s sitting and, most important, understand why. Stay close to your customers and meet often with your sales team to analyze and discuss any inventory that’s stuck on your shelves.
Gross profit margin as a percentage of sales. The percentage indicates the price you charge your customers against the prices your suppliers charge you. An increase is generally a very good key indicator, but a breakeven number or a decrease should alert you that there are flaws in your business model or that overhead is too high or prices are too low.
Profit before income tax as a percentage of sales. Ideally this figure should increase, though a flat line may be acceptable for a period. A decrease, on the other hand, may be a warning sign of further potential losses.
Once you decide on the critical three to five numbers that will determine the success or failure of your business, begin to review and digest them on a daily basis, just as you do your morning coffee or vitamin regimen. These numbers should be shared, depending on your culture and leadership style, with others in the company who must also manage to them and should be the basis for daily huddles, brainstorming and longer-term strategic planning. These numbers can also form the basis for employee-level rewards and bonuses to help you drive business growth and the achievement of your business goals.Read Part 1 of 2
“Do you know your numbers? Knowing your critical numbers starts with knowing and understanding how the numbers are generated”.