How do you know if your business is successful?
If you're like most business owners, your days are filled by efforts to make your company successful. Those tasks might be focused on making a great product, generating sales, or building customer relationships. And you might be great at those things.
But how good are you at making money and managing your resources?
While different people have various definitions of business success, there are five key financial metrics that can help you understand your business' financial success and how you're faring against competitors:
1. Pre-tax net profit margin
2. Current ratio
3. Quick ratio
4. Accounts payable days
5. Accounts receivable days
If you have someone preparing financial statements or tax returns for you, they should be able to provide these metrics easily, as well as give you additional context.
Pre-tax net profit margin. This metric is probably the most important, because it tells the owner how much profit you're making from every dollar in sales. For private companies, it is usually expressed as net profit before taxes in a given financial period divided by sales.
"A higher margin, or higher profitability, is better for a company's profit picture," said Brad Schaefer, an analyst with Sageworks Inc., a financial information company that provides financial analysis and benchmarking applications to accounting firms and private companies. "This number can show you how effective you're being with expenses and if you should decrease certain expenses so that they don't eat up as much of the revenues."
Current ratio and quick ratio. These two metrics are considered fundamental liquidity ratios, or ratios that give an idea of how well you can meet your obligations, and they should generally be analyzed together. "If the business does not have decent liquidity, then one unexpected expense could severely hurt it," Schaefer said.
Current ratio is expressed as current assets divided by current liabilities. It basically shows whether the assets that you can convert into cash quickly (within a year) will cover what you must pay off soon (in less than a year). A ratio of less than one means you could run short of cash within the next year unless you generate additional cash. But the metric has some limitations, Schaefer noted. "For example, by including inventory in the calculation, it may provide a distorted understanding of the company's very short-term cash flow," he said.
The second liquidity ratio is the quick ratio, which is typically expressed as cash plus accounts receivable divided by current liabilities. Again, the quick ratio may not be perfect for gauging liquidity, but it is a useful and popular metric to pair with the current ratio.
Accounts payable days and accounts receivable days are also key, Schaefer said. "The owner can discover that they may be paying their suppliers too quickly, which is money they could be investing instead of distributing immediately, or they could find they are not receiving payments quickly enough from their customers," he said.
Accounts payable days is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. What is a good accounts payable turnover ratio? It varies by industry, but generally, higher numbers are better.
Similarly, accounts receivable days is expressed as accounts receivable divided by sales multiplied by 365 days. Lower numbers are generally better. But this, too, will vary dramatically by industry. For example, some industries routinely give customers a 30-day grace period for payments, especially those that bill for services, and other industries don't get paid until the entire job is complete. So construction companies, for example, have an average accounts receivable days ratio of more than 60, compared with retailers' average AR days ratio of about 20, according to data from Sageworks.
Because of this variation, Schaefer said, it's tough to make sense of financial ratios unless you find quality industry data against which to benchmark your company. What is a good net profit margin? What are sound liquidity ratios?
"Without comparing your own business to others, how will you know if an account receivable days of 15 is great, average, or high?" he said.
Knowing how your metrics compare to other companies also helps you identify business areas that need fresh attention, Schaefer said.
Trade groups, surveys and information providers are among the resources for finding benchmarking data. The important thing is to find businesses of a similar industry, revenue size and geographical location.
"Business conditions can vary greatly between different areas of the nation, even if the companies are the same size and they make the same products," Schaefer said.