Just as drivers watch the instrument panel on their cars when driving, small business owners should continuously monitor the performance metrics of their company. An owner needs to know what’s working and what’s not. That’s part of managing a business. Just like it’s part of driving a car. A water temperature gauge that goes into the red zone needs immediate attention; same with a financial metric that indicates the company is running short of cash. Key financial metrics for small business fall into four primary categories:
- Profits
- Liquidity
- Leverage
- Efficiency
Within these four categories, there are seven core metrics that act as the most important key performance indicators when it comes to cash flow:
Key Financial Metrics for Small Business
Measures of Profits
Revenue – This may seem obvious, but without revenue, nothing else happens, especially profits. And all revenue starts with sales. So, the first metric to watch is your most recent sales number; it could be daily, weekly or monthly, depending on the type of business,
Are your sales at the level they need to be? Comparisons of sales figures to the budget will help to keep everyone on course to reaching the revenue goal.
Gross profit margin– The gross profit margin is an early measure of a company’s efficiency of operations. It shows how efficiently a company uses its raw materials and direct labor to make and sell a product or service at a price that produces a gross profit.
The gross profit margin must be enough to pay all fixed overhead expenses and make a profit. In some industries, a gross profit margin of 25 to 30 percent may be enough; others need a gross profit of 50 percent or more. A calculation of a company’s profit plan or break-even revenue level will determine the required gross profit margin for your business.
EBITDA – It’s nice to know you’re making a net profit, but the real test is EBITDA. That’s earnings before deductions for interest, taxes, depreciation and amortization. EBITDA reveals the true operational profits of a business without the effects of financing costs, taxes and non-cash accounting entries.
Monitoring EBITDA is important because it is an indicator of the cash flow from operations.
Liquidity to Support Operations
Current ratio– Your current ratio is current assets divided by current liabilities. The timing of the cash flow cycle from inventory to receivables to cash is not perfect. Inventory can be slower to sell and turn over; customers can take longer to pay their bills.
On the liabilities side, expenses and bills to suppliers have specific amounts and due dates – there’s no mystery, there. For this reason, you need more current assets than current liabilities. A good, comfortable ratio is to have $2 in current assets for every $1 in current liabilities. Having less could indicate that you may begin to have problems paying bills on time.
Tracking the trend of your current ratio can provide advance warnings of upcoming cash flow problems, especially if the ratio drops below 1.5.
Financial Leverage
Debt-to-equity ratio – Some debt is good; it increases a shareholder’s return on investment. But too much debt can be dangerous. Lenders have strict schedules for principal and interest payments, and they expect to receive them, regardless of the company’s cash flow availability.
Efficiency of Operations
Accounts receivable aging – The accounts receivable aging metric keeps track of all unpaid customer invoices and/or credit memos. While most customers will pay their invoices before due dates, sometimes clients can run into problems – whether their own cash flow issues or poor record keeping – which keep them from paying you in a timely manner. You should try to track invoices in 30 day buckets (30 days overdue, 60 days overdue, 90 days overdue, etc) so that you can use this information to prioritize collections procedures.
Inventory turnover– Inventory represents a significant investment for most businesses, so turning inventory into sales quickly is important. Turnover is the number of times a company buys, sells and replaces its inventory in a year. It is calculated by dividing annual cost of goods sold by the average inventory level. Depending on the industry, inventory turnover rates can reach up to 10 to 12 times per year.
A decrease in turnover could be a signal that some products are not selling well, and prices should be marked down to move them out.
Owners who regularly monitor these key financial metrics for small business will have a good sense of the pulse of their business, while enabling them to quickly spot potential problems and take corrective actions before they become detrimental to the health of your business.
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