Understanding Finances from Business Performance Indicatorsasad shaikh
Our first step in developing My Business Manager was to plan what we thought were the critical management reports that business owners need; Profit and Loss These are the trading reports that tell you if you made a profit or a loss in any period. Monthly, Quarterly, Six Monthly or Yearly. We recommend Monthly but recognize that if you aren’t already getting a set of management reports, start at Quarterly and then, when it is obvious that you need more, progress to Monthly.
Usually, the actual results are compared to budget (if there is a budget), or to the same period actual results from last year, if there isn’t a budget. Comparison to budget is often called Business Performance Indicators, whilst comparison to previous periods is called Growth.
By adding actual results to date to the remaining budget (or remaining periods from last year), you have a Forecast or Projected Results on the assumption that the business will achieve budget for the remainder of the year or that it will perform the same as last year.
Our Profit and Loss reports tell you lots of critical information about your business and it’s profitability;
- Revenue (Sales): what your Goods or Services generate.
- Cost of Sales: what did this sale cost to provide?
- Gross Profit: this will pay for Expenses, Wages and your return.
- Gross Margin: each industry has a benchmark. How does your business rate?
- Expenses: we have split this into;
- Fixed (those expenses that you incur no matter what happens).
- And Discretionary (those expenses that you can increase or decrease when required).
- This gives you more control knowing what is Fixed and what is Discretionary.
- Other Expenses: not directly related to the running of the business.
- Other Income: from non-business sources.
- Interest: can be a major expense if you are running an overdraft.
- Tax: by providing for tax, you know what you need to pay.
- Net Profit: your reward and to keep for future needs. Taken to the Balance Sheet as Current Earnings.
- Net Profit Margin: check your industry for the benchmark.
Balance Sheet – These are the Business Value reports that tell you how the business is performing as an investment. It tells you where the money comes from and where it is used within the business.
Lots of businesses don’t look at or even produce a Balance Sheet report and yet we believe that it is extremely important to know the financial health of your business every month. It is the Balance Sheet that indicates whether the business is healthy or not.
To make this information easier to read, we decided to extract certain values and to display them separately. This allows further control and the ability to convert critical values into KPIs (Key Performance Indicators). These are values that help you to see trends in the information rather than plowing through large volumes of data.
Our Balance Sheet reports include;
- Cash at Bank: includes all bank accounts, credit card collections, petty cash, and cash equivalents with no risk attached.
- Accounts Receivable: Sales made that you have not yet been paid for. You are in effect, lending your customers money to purchase your Goods and Services.
- Inventory (Stock): goods and materials held for resale.
- Other Current Assets: pre-paid expenses.
- Fixed Assets: Property, plant and equipment.
- Investments: including investment property.
- Other non-current assets: intangibles such as software, intellectual property, biological assets at estimated value.
Total Assets – equals Current Assets plus Non-Current Assets.
- Short Term Debt: any debt that is due within one year
- Accounts Payable: payments owed to Suppliers. They are in effect lending you money to help finance your purchases and to grow your business.
- Other Current Liabilities: items not assigned to Debt or to Accounts Payable. This is to simplify the Balance Sheet rather than listing any items separately. E.g. Unearned revenue, paid by customers but the service has not yet been provided.
- Long Term Debt: loans due more than one year in the future. This can include Overdrafts, deferred tax liabilities, Directors loans.
- Other Non-Current Liabilities provisions for long term liabilities.
Total Liabilities equals Current Liabilities plus Non-Current Liabilities.
Net Assets equals Total Assets minus Total Liabilities. This is what your business is worth.
- Share Capital : funds from the sale of shares. Often, in smaller businesses, this is a nominal amount. Director’s loans (Non-Current Liability : Long term debt) are often converted to Share Capital at the time of additional investors coming into the company.
- Retained Earnings : how much profit (or loss) the company has made since it started up to the beginning of the current trading year.
- Current Earnings : how much profit (or loss) the company has made this financial year. This is a cumulative field, being added to each month. At the end of the financial year, it is added to Retained Earnings and then this value is re-set to zero.
Net Assets is always equal to Equity. (That is why it is called a Balance Sheet).
Cashflow (often called Funds Flow because it shows where the cash comes from and where it is used within the business).
Often, business owners wonder why they have no cash despite knowing that they have made a good profit. The main culprits are Accounts Receivable, Inventory and spending it on Wages and Expenses.
Making a profit is a lot different to having good cashflow and it is vitally important to know the difference. Most businesses fail due to lack of cashflow rather than from lack of business.
Except for Current Earnings (which comes from the Profit & Loss), all other items come from the Balance Sheet so you can appreciate why it is so important to receive and understand.
To make the Cashflow logic easier to understand, we have used colour coding to indicate whether each activity Increases Cashflow or Decreases Cashflow.
Using the Budgeting logic, we can forecast Cashflow requirements into the future.
Our Cashflow reports show;
- Accounts Receivable: also known as Debtors. You are effectively lending money to your customers (usually interest-free) to allow them to purchase your products. This is one of the critical items for cashflow and often causes the most angst. We will advise how to manage this effectively in a later blog.
- Inventory: also known as Stock. This is another critical item and needs to be finely balanced between being able to supply against orders and not running out of stock. We will advise how to manage this effectively in a later blog.
- Other Current Assets: such as pre-paid expenses.
- Accounts Payable: also known as Creditors. Whilst from a Cashflow point of view, this is someone else lending you their money (usually interest-free), you need to be careful to keep your suppliers happy by paying when the debt is due.
- Other Current Liabilities: such as unearned revenue, paid by customers but the service has not yet been provided and provisions for tax.
- Current Earnings: brought forward from the Profit and Loss. If you made a profit, there is cash left over. If you made a loss, it has depleted your cash.
Total Operating Activities
- Short Term Debt: due for repayment within 12 months.
- Long Term Debt: overdraft, director’s loans, notes, debentures etc.
- Other Non-Current Liabilities: provisions for long-term liabilities (such as Long Service leave).
- Equity: increases in equity bring in more cash, Dividends are paid from cash.
Total Financing Activities
- Fixed Assets: purchasing fixed assets uses cash, sale of fixed assets generates cash.
- Investments: often, businesses have made investments with spare cash and they generate income (or expenditure). Interest, rental income etc.
- Other Non-Current Assets: may generate income such as license fees for access to IP.
Total Investing Activities
Total From All Activities
We then show;
Net Movement in Cash
- Opening Bank Balance
- Plus or minus Total Cash from All Activities
- Closing Bank Balance
Hopefully, by seeing the details of where the cash is coming from and where it is being used, it will focus you on managing these areas.
Due to the tough business environment, we are intending to develop a detailed Cashflow Analysis that uses transaction-level data to show Cashflow requirements week by week.
Financial KPIs (Key Performance Indicators): these indicators are used to indicate business health and performance and are used as a short-cut rather than using large volumes of data and values.
Some Financial KPIs come straight from the Profit and Loss or from the Balance Sheet but are usually calculated from several values.
There are hundreds of KPIs but we have selected the Top 15 most commonly used by Accountants, Business Consultants and Business Coaches.
By tracking the movements and trends of Financial KPIs, you will have strong control over the business.
Balance Sheet Drivers
- Days Receivable: the number of days, on average, that it takes to collect payment for an invoice. This is one of the most critical KPIs and needs to be carefully monitored.
- Days Inventory: the number of days of inventory held, based upon average usage per day. Certain industry segments have a benchmark guideline. Your business association can advise you.
- Days Payable: the number of days, on average, that it takes you to pay for Goods and Services that you have purchased.
- Gross Margin % – this indicates the proportion of Gross Profit that you are making on the sale of your Goods and Services. This is an important KPI as it indicates whether your Cost of Sales is increasing or whether you are discounting. It is vitally important to maintain a healthy Gross Margin as this pays for your Expenses and your own salary.
- Profitability % (based on Earnings before Interest and Tax) this KPI indicates profitability independently of whether the business borrows money and independently of tax payable.
- Net Profit Margin % – this indicates the Net Profit available to the Business Owner from each Revenue dollar. It is the amount left to use to grow your business. Often, in the early stages of business, the owner doesn’t take a commercial salary, therefore any salary taken comes out of Net Profit.
- Return on Investment (ROI): most business owners forget that their business is an investment and therefore should show a healthy return on the funds invested. After all, if I asked you for a loan and told you that there would be no return (or worse, a loss), you would probably not lend me any funds. A good benchmark is to determine whether this return on your investment is comparable or better than other potential investment opportunities. If not, are there other considerations? Either way, you should review this return to see how you can improve it.
- Interest Cover: this KPI shows the number of times that EBIT (Earnings before Interest and Tax) covers the interest cost. If this trend is reducing, it means that the cost of borrowing is increasing compared to earnings.
- Gross Cashflow: Cashflow shows what the net movement of Debt, Cash Receipts, Payments and Capital Movements has been since last year. If it is positive, you are increasing your available working capital. If it is negative, you need to be concerned about working capital and debt levels.
- Current Ratio (also known as Working Ratio): this KPI shows how many times your business’ Current Assets are greater than it’s Current Liabilities. This KPI ratio is used by lenders to determine the viability of a business and it’s ability to service debt. Check with your advisor to see what this range should be for your type of business.
Investment / Equity / Capital
- Funding Ratio: this KPI shows the health of your business’ equity. Ideally, your equity should be greater than your debt, however in some industries, it is common to leverage equity multiple times. Check with your advisor to see if your ratio is within the range for your industry.
- ‘Net Worth (or Gearing): this KPI shows the position of your business’equity to it’s total assets. High equity % gives more stability to the company rather than debt financing the purchase of assets. A decreasing Gearing ratio is usually caused by the acquisition of assets by using debt. Either raise more equity to fund growth or review the assets (usually inventory and Receivables), to make sure that they are being controlled.
- Borrowed Funds: shows the total amount of Short term debt and Long term debt outstanding. When assessing funding requirements for your business, you may find it helpful to discuss with your lender, the amounts and terms of your expected borrowings. This avoids you having large Short term borrowings that are vulnerable to higher market rates and unforeseen changes to your financial arrangements.
- Debt to Equity – this KPI shows the health of your business debt. Ideally. Your equity should be greater than your debt, however this is usually not possible due to the high cost of funding the business and it’s inventory. An increase usually indicates an increase in debt as equity doesn’t move radically. Make sure that this situation is part of your business plan and budget, and that your advisor and lender are aware of why this is increasing. Always make sure that debt is aggressively managed.
- Return on Capital Employed (ROCE) this KPI shows the net profit as a percentage of your business’ net assets. This ratio is used heavily by investors to indicate what level of return they may expect from their investments. A business owner is also an investor and should be aware of what that return is. It should be factored into the reward that the owner receives from the business. If you can get a better return on your funds elsewhere, make sure that you understand why your funds are invested here. Funds invested in a business should significantly out-perform funds invested in day-to-day investments as the risk element is much higher. To improve ROCE, increase profits, reduce expenses and reduce working capital needs.
Once you understand what these KPIs mean and what they indicate, you are empowered to manage them and to improve the results!