Many small and mid-sized businesses have found themselves in a tough spot during the coronavirus health emergency as lower sales resulting from lockdown measures, business shutdowns, and lower foot traffic have resulted in losses.
Now that the world is progressively emerging from the pandemic and the development of a vaccine is closer to reality, it is a good time to reflect and plan for how to strengthen your business finances once things begin to normalize.
To help business owners in this endeavor, business consultant Jasdeep Singh provides the following five metrics that entrepreneurs should use to assess and improve the performance of their businesses.
Metric #1 – Gross Profit Margin
Higher sales are good news for any business.
The most successful entrepreneurs understand that revenues and cash flow are the lifeblood of any company. Higher revenues can lead to higher profitability and greater cash flows, which in turn result in opportunities to reinvest in the business and its resources.
However, higher sales do not necessarily turn into higher profits. Businesses need to keep an eye on profit margins to ensure they are making enough money from their sales.
Gross profit margin is a simple measure that tracks the percentage of sales that the business is keeping to pay expenses and cover liabilities.
This metric is calculated by deducting the cost of goods sold (COGS), or all direct costs related to the production of the goods the business sells, from the total revenues. COGS include all of the costs related to the product, such as raw materials, labor costs, manufacturing overhead, and other similar items.
Once those costs are deducted from the business net revenues, the resulting amount is divided by net revenues and multiplied by 100 to obtain the percentage. This percentage indicates the portion of the business sales that the company keeps covering its fixed expenses. The higher the margin, the higher the chances are that sales can cover other costs and translate into profits.
To gain an even clearer picture of what is happening in terms of revenues and margins, companies can try to utilize activity-based cost (ABC) accounting methods to understand the variable and fixed costs associated with each product sold. ABC accounting, while more time consuming to set up, helps leaders differentiate the profit margins for each of the products the company sells.
Metric #2 – Operating Expenses to Sales
Operating expenses consist of all the day-to-day disbursements required to keep a business running, including rent, utilities, salaries, and office supplies. They include a mixture of variable and fixed costs.
Operating expenses are natural costs that every business has, but keeping them in check can significantly increase the chances of producing a net profit once those expenses are deducted from the business’ gross profits. One of the main responsibilities of those in charge of a company’s finances are to track these costs since they impact every product produced. High operating expenses, relative to sales, are a warning sign because of the drag it produces on the company’s finances.
The goal is to reduce the percentage to the lowest possible level without negatively affecting the business’ quality of service. This, in turn, lowers the break-even point for the company in terms of sales, which is the minimum amount of revenues the company needs to bring in to cover all costs and begin to make a profit.
Metric #3 – Free Cash Flow to Sales
Free cash flow results from deducting the business’ essential capital expenditures, asset purchases that the business needs to run, maintain, or improve its day-to-day operations, from the company’s net operating cash flow.
Free cash flow is a centerpiece of a business’ strategy to grow as it allows managers to invest in new profitable projects.
While most new businesses struggle to generate free cash flow in their first years as they try to grow their sales and infrastructure, it is still important to keep free cash flow in mind. This dynamic stage of growth may require almost all cash go towards operations, but every dollar that can be utilized for reinvestment in the company can pay dividends through optimized operations and increased revenues.
However, as the business matures and reaches a stage in which sales grow at a more stable pace, companies should be able to better plan for free cash flow. By tracking this metric as a percentage of sales, businesses can forecast how much money they will have at their disposal during a certain year based on their revenue projections for that period. Those resources can be put to use as the year advances to fund the company’s expansion projects.
As Dr. Singh puts it: “It is essential to have a sound understanding of your strengths and areas of growth because only then will you be able to analyze opportunities for their possible impact on your business and future profitability.”
Metric #4 – Return on Equity
Starting or running a business is a risky activity.
Building a business requires a commitment from its equity holders to put their money at risk and they, in turn, demand compensation for taking on that commitment.
The return on equity metric tracks the percentage of return that equity holders may obtain from the company’s activities, measured by the business’ net income after taxes.
The return on equity (ROE) is calculated by dividing the net income by the company’s equity capital including all reinvested earnings and other equity items.
This percentage should be compared to the percentage that similar businesses in the same industry generate for their shareholders.
The whole purpose of this metric is to show how much equity holders are receiving for their investment in the company, whether in the form of a percentage of profit or as reinvested earnings.
The higher the percentage is, the most valuable the business will be, especially when it comes to selling the business to a third party.
Metric #5 – Interest Coverage & Other Debt Ratios
The interest coverage ratio (ICR) is a metric that expresses how many times the business’ interest expenses are covered by its operating profits.
A higher ratio means that operations generate more than enough money to cover for any interest-related financial expenses.
Meanwhile, certain other ratios such as the debt-to-assets ratio or the debt-to-equity ratio monitor how much debt your business has taken in relation to its assets and capital.
Those ratios should be kept in line, especially in a situation where revenues are uncertain, as they could end up deepening the business’ losses if the company fails to generate revenues above its break-even point.
Wrapping Things Up
Although these are just a few of the financial metrics a business owner should watch, they are some of the most powerful when it comes to assessing the company’s performance over time. Other metrics such as the inventory turnover rate, the current ratio, and the revenue growth per segment or product line can also help, but they usually demand a much closer analysis of the business.
By keeping an eye on how these metrics evolve while your business progressively reopens you can get a better perspective on what has to be improved and what is working in the current environment. The ultimate goal is to catch any possible issues that are the common downfalls of companies (ex. high expenses, low debt-to-asset ratio, low cash flows) early enough to make plans for capitalizing on strengths and making necessary changes.