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The True Measure of a Business Lies in its . . . Measurement

Measurement is key to improvement

Measurement is Key to Improvement

Happy 2014! By now all the holidays are past and you are reasonably recovered and ready to take the world by storm in the new year, right? Before you apply all that enthusiasm and energy, let’s take a few minutes (OK, hours actually) to analyze what happened in your business in the last year. The insights you gain will be an important factor in how quickly you achieve your goals over the next 12 months.

You probably already do a good job of evaluating your Balance Sheet and your Operating/Income Statement at the end of the year. And those of you truly on top of your game are analyzing your Balance Sheet quarterly and your Operating/Income Statement monthly. If you’re not, though, let’s quickly review the elements you should be carefully examining in those two reports.

Balance Sheet Measurements

Your company Balance Sheet is the report you use to analyze the strength and stability of your business. The measurements you should look closely at are:

  1. Liquidity.  In the Current Assets section of your Balance Sheet you will see the values for cash in bank accounts, other types of accounts that can be easily converted to cash (like certificates of deposit – CDs -, Treasury Bills, or notes), accounts receivable, and inventory. In the Current Liabilities section of your Balance Sheet you will see how much you owe through accounts payable, short-term loans or notes, and any accrued expenses (expenses your company has not yet paid but will pay shortly).The Current Ratio, also known as a liquidity ratio, helps you analyze your ability to meet your current financial responsibilities. The math is simple: just divide your Current Assets by your Current Liabilities.  For example, if your Current Assets are $1.2 million, and your Current Liabilities are $900,000, then your Current Ratio is 1.333 ($1,200,000 / $900,000 = 1.333).  If your Current Assets are $800,000 and your Current Liabilities are $1.3 million, then your Current Ratio is .615 ($800,000 / $1,300,000 = .615).How does this measurement help you? A Current Ratio less than 1.0 is a strong indicator that you are in a weak position to pay all your financial obligations. You want to maintain a Current Ratio of 1.0 or above. Once you know your ratio, consider all the steps you can take to improve your Current Assets and reduce your Current Liabilities. Doing this work will set you off on the right foot for the coming year.
  2. Turnover. In accounting, turnover refers to the number of times you turn an asset into cash in the accounting period. You are probably accustomed to analyzing your inventory turnover, but you should be managing your accounts receivable turnover as well.
    1. Inventory Turnover. The simplest way to calculate inventory turn is to divide sales by inventory. For instance, if your  sales for the year were $2 million, and you currently have inventory of $1.2 million, then your turnover ratio would be 1.6 ($2,000,000 / $1,200,000 = 1.6). Your goal should be to turn your inventory three to four times per year in order to generate sufficient cash for growth. For a very thorough evaluation of several inventory turnover calculations you can read this entry in Investopedia.
    2. Accounts Receivable Turnover. If most of your sales are made on credit cards or on terms of less than 15 days – and if your accounts are up-to-date – then this turnover ratio won’t be as important to you. But if you have a lot of accounts paying 30 or more days after receipt or sitting on a lot of memo goods, then you must watch your Receivables Turnover carefully. Why? Because you are basically extending interest-free loans to your customers, and you must maintain efficient cash management in order to continue to do so. The calculation for Receivables Turnover is Net Credit Sales divided by Average Accounts Receivable.Getting to Average Accounts Receivable can be tricky for most people, and if you’re not using an adequate accounting program it will be almost impossible. Assuming you are using an accounting program like Quickbooks, Simply Accounting, Freshbooks, or Great Plains (etc.), I recommend pulling a Balance Sheet for each of the previous four quarters, adding the Accounts Receivable balances from the four Balance Sheets together, and dividing by four. This will give you a good view of your Average Accounts Receivable for the past year.  Once you have that number, you must determine your Net Sales on Credit (and by this I mean terms, not credit cards – any sale for which you extended pay terms to the customer) for the past year.  Again, this requires use of an adequate accounting system.  Then you divide the Net Sales on Credit by Average Receivables.  A Ratio of 12 or higher indicates that you are doing a good job of maintaining your cash position. A Ratio of 6 or lower indicates a strain on cash, particularly for a small business. The lower your ratio, the harder you need to work on decreasing the number of days payable you extend to customers and making sure customers pay within the terms you have extended them.

Those are the big metrics you should evaluate from your Balance Sheet.  Now let’s look at your Operating/Income Statement.

Operating/Income Statement Measurements

You already know to look at your total sales and net profit. Here are a few other things you should evaluate when preparing for the upcoming business cycle:

  1. Gross Profit. Gross Profit is the amount of money you have left to run your business after Cost of Goods is subtracted from Sales.  The easiest way to increase cash flow in a business is to decrease Cost of Goods, leaving you with more money to pay for everything else! Try covering up the top part of your Operating/Income Statement so the first line you see is Gross Profit. Are you happy with the amount of money you have to work with? If not, start thinking of ways to improve your Gross Profit in the next 12 months.
  2. Marketing and Advertising as a Percentage of Sales. “If you build it, they will come” only works for Kevin Costner.  For the rest of us, we must build it, and then advertise, market, and sell like crazy. Add together your expenses in marketing, including promotions, advertisements, photography, web promotion, social media, trade shows, magazines, public relations, etc. Together, your marketing expense should be equal to 6% – 8% of revenue for a company that is just maintaining its volume, and 8% – 11% for a company that is trying to grow*. If you’re not spending enough money on your marketing activities, there’s a good chance you’re not getting in front of enough customers.
  3. Information Technology. Whether or not you’ve embraced this fact, your business is increasingly dependent on technology to remain competitive. You should be spending 2% – 3% of revenue each year on replacing computers, maintaining and upgrading business systems (sales automation, marketing automation, operating systems, etc.) and maintaining your technology infrastructure. If you’re not investing properly in technology on an ongoing basis, you’ll find it increasingly difficult to catch up as your competitors move ahead of you.

Finally, ensure that you are setting strong enough growth goals. Growth goals of 5% or less are practically stagnant. It is entirely reasonable to experience growth over 10% year after year – and I know of several jewelry companies that experienced 18% + growth in 2013. Set your goals high and put the plans in place to achieve them.

Performance Analyses

  1. Big Wins. Analyze your products and see which ones represented your best-sellers this year. Look at patterns in price points and product types. Can you gain insight that will lead you to stronger product offerings in the year to come?
  2. Big Drags. Conversely, which products represented the biggest drain on your resources? Which products are currently sitting in your inventory (or your customers’ inventory) and failing to capture the imagination of the consumers. Let’s do less of those.
  3. Customer Performance. There are several types of customer performance analyses that will help you serve current customers better and target more customers like them.
    1. Top 20% Customers by Dollar Sales.
    2. Top 20% Customers by Margin. Surprisingly, some of your best dollar profit customers may not be in your top sales percentage bracket. Make sure the customers you consider your best customers are producing for you in terms of both sales and profit.
    3. Top 20% Customers by Repeat Purchase. Who are the customers who come back repeatedly to refill their cases after sales? What can you learn about these customers that might help you turn other customers into better repeat purchasers?

I could come up with dozens more metrics for you to analyze, but if you do just these evaluations you  can significantly improve your business this year. And once you’ve done each of these, if you’re having a blast and want some more metrics to try out, just drop a line in the comments and I’ll give you a few more :) .

 

* These marketing benchmarks are based on expectations for retail and designer/manufacturer businesses in the jewelry and luxury small goods segments.

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