Part 5: Stewardship and the Numbers, Continued
By Art Zylstra | Guest Writer
Key Financial Indicators
Key financial indicators are important measurement tools for business. These indicators are determined based on the information recorded on the three statements outlined in my previous post. While it isn't critical for an owner to remember how to calculate each of these indicators, it is important that an owner is monitoring the results of the business with these tools. The following is a limited list of many of the indicators a business should monitor.
• Current ratio: Current assets ÷ current liabilities
• Debt to equity ratio: Total liabilities ÷ net worth
• Debt to asset ratio: Total debt ÷ total assets
• Debt service coverage ratio: Net operating income ÷ total debt service
• Quick ratio: (Cash + marketable securities + accounts receivable) ÷ current liabilities
• Leverage ratio: Debt ÷ EBITDA
• Gross margin: Gross profit ÷ sales
• Operating margin: Operating profit ÷ sales
• Net profit margin: Net profit ÷ sales
• Sales to assets ratio: Sales ÷ total assets
• Return on assets ratio: Pre-tax profit ÷ total assets
• Return on equity ratio: Pre-tax profit ÷ equity
• Inventory turnover ratio: Cost of goods sold ÷ average inventory
• Days in inventory ratio: Days in inventory period ÷ inventory turnover
• Accounts receivable turnover ratio: Sales ÷ accounts receivable
• Days outstanding: 365 ÷ accounts receivable turnover
• Accounts payable turnover ratio: 365 ÷ accounts payable
• Payable period ratio: 365 ÷ accounts payable turnover ratio
• Sustainable growth rate: How fast you can grow without increasing your debt to equity ratio
• Break-even analysis: (Fixed expenses + interest) ÷ gross margin
• Twelve month trailing charts: Rolling twelve-month totals of income and expenses to measure year-over-year progress
Key Performance Indicators (KPIs)
In addition to the financial indicators listed above, a business owner should also be aware of the key functions that drive the business and monitor them over time. A KPI should be able to tell the owner how the business is performing in a particular area at a glance. Like a vehicle dashboard, a series of KPIs will be able to show the performance of the business. The key to building a relevant dashboard is to figure out what performance areas are most important for your business and your industry to understand, track, measure and monitor over time. KPIs are designed to be monitored on a regular basis.
One KPI that every business should set up and regularly monitor is a budget. The budget is set in advance based on your best understanding of what needs to happen to accomplish the goal for the year. Each month the actual financial results should be compared with what was expected in the budget. This will provide an indicator of whether a course correction needs to happen.
In addition to budgets, a business owner should occasionally be looking at a more fluid 3 to 6-month forecast based on current trends and results. With proper KPIs in place the business owner will be able to identify any areas that need extra attention and make adjustments as necessary.
One area of business many owners struggle with is the amount of cash to keep on hand. If an owner keeps too little cash on hand, a bump in the road could lead to a missed payroll or they may miss an opportunity to purchase extra supplies or inventory at a discount. On the other hand, when an owner holds on to too much cash they might tend to not invest back into the company with upgraded equipment, or they might not be willing to give out a raise or well-deserved bonus to employees. These and other scenarios could lead to long-term damage to the company.
The first step to stewarding cash is to look at the historical needs of the company. Have there been periods of fluctuating cash in the past? What were the causes? Do seasonal sales affect your cash? Have you had a few large customers draw out paying their accounts receivable? Did you make large inventory or equipment purchases with cash? The greater the understanding about historical cashflow, the better one can anticipate future fluctuations.
The next step is to look forward and factor in your plans. Do you plan to invest resources into growing sales rapidly? Will you need major equipment repairs shortly? What are you anticipating doing in the future that will affect cash? Understanding the stage of your business life cycle will be a factor as well. Are you burning through cash as a startup? Are you planning on expanding your business? Are you building your infrastructure to grow or sell? Each of these factors will play a part in how much cash is needed.
The availability of bank financing will play a major role as well. If you have a line of credit available, then it isn’t as important to have a nest egg to carry you through a short-term cash shortage. However, if you are highly leveraged on debt already, then your cash should be working hard at reducing debt.
Longer term cash management factors include investing in your employees for long-term retention. There should also be a regular equipment replacement plan to upgrade old equipment. A good rule of thumb is to spend an equal amount on upgrading equipment as your annual depreciation expense. Investing in strategic product innovation should be a continual cash outlay as well.
Ultimately, most of your cash retention decisions will be based on the intersection of profit and loss. This intersection is called risk. The more risk a business owner accepts, the less cash they will likely retain. A high risk, big return business person will likely be leveraging people by paying the minimum amount of pay possible, taking the maximum amount of cash out of the business for personal use and using as much debt as they can to leverage the operations of the business. This, in my estimation, is poor stewardship of business.
About the AuthorArt Zylstra brings over 35 years of experience stewarding resources and people to small-to-midsize private and nonprofit organizations to help them flourish and grow. With his MBA in organizational leadership and a doctorate in transformational leadership, Art collaborates with key members of the executive team to develop and implement key strategies across the organization, providing leadership and coordination in its administrative, operation, business planning, accounting and budgeting efforts. He is highly motivated by mission and operates with integrity, confidence, professionalism and resourcefulness in a way that allows all stakeholders of the organization to flourish.
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