Measuring the performance of a business is essential to business success. Every business owner does this in one way or another. There are very many measures to choose from, including a large variety of ‘ratios’. The problem is that, to be useful, it is really important to properly understand what the measures mean and many of them can appear confusing and difficult to understand.
To drive your business successfully you need to become good at the controls and understand what the dials are telling you. You don’t need to understand every accounting measure and ratio to run a small business successfully – just select the ones that are most appropriate for your business and make sure you understand those really well.
So, which are the most appropriate and important measures for a small business?
In our experience the most effective measures for most small businesses are:
- Those that ensure the business does not run out of cash – because this a key reason for bankruptcy
- Those that ensure the business makes a profit each month
The first set are ‘balance sheet’ measures ; the second set are ‘ Profit & Loss (P&L)’ measures. Let’s look at commonly used measures for each.
Cash measures:
Running out of cash is the main reason for small business failure. Your business can run out of cash even if it has made a profit every month and is growing fast. Cash is not profit. Look at the (very) simple example below to illustrate this. To ensure cash is very tightly managed many businesses have a 14 week rolling cashflow forecast – this shows every expected cash payment by the company and every expected cash receipt and the net bank balance at the end of each week. Of course it is a plan and needs constant attention as things change, but the clear objective is to have a detailed plan to ensure that the cash balance remains in the black. Possibly the most useful balance sheet measures to help in cash management are:
- Debtors (and debtor days) – which measure how much money your company is owed by your customers
- Creditors – which measures how much your company owes to your suppliers
- Stock – measures how much money is tied up in inventory
Balancing debtors and creditors is one of those essential skills every business manager needs if cash problems are to be avoided.
Profit & Loss (P&L) measures:
The most important measures can generally be boiled down to just 4:
- Sales – usually the amount you have invoiced your customers
- Cost of goods – usually the direct costs associated with the ‘sales’
- Gross Profit – the difference between the two measures above
- Overheads – the (reasonably) fixed costs of the business
- Net Profit – just Gross Profit less Overhead costs
This simple example below may help illustrate these measures.
You start a company with your savings of £1,000. You are going to distribute a product and strike a great deal with a supplier to buy the product at £5 each. You are sure you can sell them at £10 each. Your business overheads are a flat £400 a month, paid in advance. In the first month you sell 100 units at £10 each and place an order for the 100 units on the supplier, paying the supplier (who wants cash up front) £500. The product is delivered at the end of the month and the customer transfers the full £1,000 into your business bank account on the last day of the month. This all looks good – in the first month the sales are booked at £1,000, less cost of sales of £500 giving a Gross Profit of £500, less £400 of overhead costs, leaves the business with a net profit in the first month of £100. The bank account which started with £1,000 reduced to £600 after the overheads were paid and reduced further to £100 after the supplier was paid, but then increased to £1,100 when the customer payment was received. This is looking great, isn’t it – the business is off to a good profitable start – time to scale up and make, not £100 a month profit, but £1,000 a month profit. Tally ho !
Inspired by the success of the first month, the customer, who was very pleased with your responsive service, says you can have an order for another 200 units for delivery in the second month on the same terms, ie an order for 200 units at £10 each (£2,000) and the supplier will be paid £5 each (£1,000). So the P&L for the second month will look like: sales of £2,000 ; Cost of goods at £1,000 ; giving a gross profit for month two of £1,000 ; and with overheads staying at £400 this leaves a net profit for the second month of £600, up from the £100 in month one. This company is doing really well – sales and profits are rising fast. What could possibly go wrong? Let’s look at the cash position in month two. It starts at a balance of £1,100 and then drops to £700 after the overheads are paid. Now we just need to place the order on (and pay) the supplier. Unfortunately the supplier still insists on payment (of £1,000) up front and as there is only £700 in the bank account the result is that the company does not have enough cash to pay the supplier for the full order.
In general:
- A growing business will require more cash
- A company can grow and be profitable every month but still fail, due to lack of cash
- Gross Profit is a measure of a company making money
- Overheads are the fixed costs and measure the company spending money
- To ensure a net profit every month, ensure that Gross Profit exceeds the overheads, ie the company makes more than it spends
The number one cause of business failure is running out of cash. There are three things an SME needs to do to manage cash effectively: