We all remember the days when we got a report card from school? Now that we have a business, it has a report card as well. Don’t get that sick-in-the-gut feeling, these are actually quite helpful, but it’s up to each business owner to calculate them. Here are some “grades” to compute for your business to give it a report card of its own. We recommend tracking these measurements and ratios on a regular basis to guarantee a fresh sense of the health of the business.
Note: to keep the “school report card” theme going, we’re going to use the old ABC grading scale. Most business owners are doing these calculations in Excel so conditional formatting might make more sense. Instead of the ABC format, consider using green, yellow, red much like Alan Mulally did during his tenure at Ford.
At Lucrum, we talk a lot about the “Financial Fitness” of client’s business. These are some key measurements to track that when taken together paint a detailed picture of one’s overall health. It is important to recognize that these grades don’t live in a vacuum; they are more meaningful when taken together.
This ratio measures profitability as it relates to the investment or money tied up in a business. Why is this important? It provides insight into how the business is able to reinvest its earnings to fuel growth. The formula is net income / average equity. An ROE of 15% – 20% is an “A” for your business report card.
This ratio measures how effectively business assets are used to generate profits. In other words, what the business is able to do with what it has. The formula is net income / total assets. An ROA of five percent or more is an “A” for your business report card.
This ratio measures efficient use of business assets. The formula is sales / total assets. This number should be high for low margin businesses and low for high margin businesses.
Depending on the business, it might make more sense to track inventory turns than asset turnover. The formula is similar – sales revenue / average inventory. This calculation tells you how efficiently you are managing your inventory. For an e-commerce business, a score of 5-6 would earn you an “A”.
How profitable is your business? Most business owners know your bottom line number, but there’s more to it.
This ratio measures the financial health of a company as it relates to how much money is available to cover overhead. Calculate it as follows: (revenue – cost of goods sold) / revenue.
Industry advice will differ, as lower overhead businesses will not have the same requirements, but some say a range of 25 to 35 percent is normal for typical small business to earn an “A”. However, those businesses with heavy cap-ex requirements may have margins in the 40-50% range to get an “A”
Net profit margin measures how profitable a business is in relation to the amount of sales generated. As an example, a business that can make $50K in profits on $500,000 in revenue is more healthy than one that makes the same $50K profits on $3 million in revenue. The formula is net income / total sales, and although it depends on the industry, a net profit margin over 10 percent is usually considered an “A.”
Don’t forget to include leading indicators into your report card. Lucrum’s 2019 word of the year is Cash Flow, and our post introducing this concept can be found here. Forecasting cash flow gives insight into your coming needs, and comparing the grades above with cash flow projections allows a business owner to develop a more informed plan.
To calculate the Operating Cash Flow Ratio of a business take the Cash Flow From Operations / Current Liabilities. If the result is over 1.5, give yourself an “A” This means that the business can cover its current liabilities 1.5X which generally leaves sufficient reserves for long-term debt, investments, or reserves.
How does your business report card look? Knowing these numbers gives invaluable insight into where a business needs improvement. Without tracking these grades, we are flying blind, and have no strategic ability to grow. If you aren’t tracking the financial fitness of your business regularly, give Lucrum a call. Our goal is your success. We can help not only determine these grades today, but more importantly how to improve them over time.