Source: Sue Hirst (CAD Partners – 1800 362436)
Ever look at the reports from your accounting software and get over-faced by all the numbers? Do you not bother printing out the reports at all because you aren’t sure which numbers to look at, and you don’t have the time anyway? You would not be alone if you answered yes to either of these questions.
A typical set of financial reports (i.e. Profit and Loss Statement and Balance Sheet) contains a lot of numbers and it can be a daunting task to make sense of it all and know which numbers are the important ones. Of course they are all important but some are absolutely critical to financial success in business.
Most of the ‘Seven Key Numbers’ are not contained in a typical set of financials, which is a frightening thought, considering they are absolutely vital to profit and cash-flow. This is because these numbers are ‘Financial Drivers’ rather than ‘Results’. The typical financials provided to most business owners are for tax purposes rather than management use.
The seven key numbers to drive profit in a recession are
- Revenue Growth
- Price Change
- COGS (Cost of Goods Sold)
- Operating Expenses
- Days Receivable
- Days Payable
- Days Inventory/Work in Progress
Let me explain why these seven numbers are so critical.
Business owners focus a lot of attention on Revenue and making sales and this is obviously critical. What is even more critical though, is what those sales cost you to make, and also cost you to fund. As soon as you sell something, and often well beforehand, there are costs involved e.g. goods for sale, freight, labour, overheads etc. It’s critical to know these costs, because if they exceed your revenue then you are making a loss and heading for cash-flow problems.
The reason Revenue Growth is important is because business growth is often the killer of small businesses. How is this so? Because so many numbers besides Revenue are important to profitability, if the other numbers aren’t being managed right, revenue growth will just exacerbate cash-flow issues. If it’s not a good situation it won’t get better, but it will get much worse. Revenue Growth is cause for celebration but it’s also cause for attention to other ‘Key Drivers’.
Means the percentage increase or decrease at which you sell your products or services. In a highly competitive marketplace it’s tempting to sell for the cheapest price possible. This is fine, but if you’re not covering costs with the price you are charging, then you are not going to make a profit. You may be discounting some products or services in order to gain business for other more profitable ones, and that’s fine. A trap many businesses fall into, is failing to increase prices regularly by small amounts e.g. by the Consumer Price Index (CPI). Failing to do this can cause margin squeeze. This means, your gross profit suffers, due to reduced revenue, compared to the costs of delivering the goods or services. Customers can get a shock if you’ve never increased prices and suddenly make a large increase, whereas regular small increases are much easier to achieve. Example, I occasionally visit McDonalds for breakfast. I noticed just recently that the cost of my breakfast was $8.90 when last time it was $8.50. That was a 4.7% price increase. It was barely noticeable and I, as a customer, won’t take my business elsewhere for the sake of an extra 40cents. This increase is probably quite justified with increased petrol and costs to deliver the product. Love them or hate them, that’s part of McDonald’s success!
Many business owners fear losing customers by putting up prices. The reality is that you may not lose as many as you think. If you do lose a small number of extremely cost conscious customers, it may not be such a bad thing. Modeling can show that increased price and reduced overall revenue could, in some circumstances, actually have a positive impact on your bottom line. You could increase prices selectively to less valuable and new customers, and offer existing prices to your better customers.
‘Cost of Goods Sold’ means the costs incurred to get the product or service to the customer, before taking into account Overheads. This is often referred to as ‘Direct Costs’ or ‘Variable Costs’. This is a really important number as it has a huge impact on your Gross Profit and an even bigger one on your Net Profit. Many business owners focus a lot of attention on Revenue and this is important but a small reduction in COGS can have as much impact on Gross Profit as a large increase in Revenue. Often a little attention to what makes up COGS, and some negotiation or investigation with suppliers for better prices, can pay huge dividends on your Gross Profit. If you are a service based business, attention to work practices and job management can have the same effect on your Gross Profit. E.g. knowing how many labour hours you are selling compared to those you are paying for, provides opportunity to investigate differences and tighten up processes.
Many business owners focus attention on the Overheads in the Profit and Loss Statement without comparing them relatively, (by percentage) to the Revenue. It’s important to compare them by percentage as this has an impact on the profit. If you just look at the Overheads dollar figure you could be making more Revenue without increasing your Net Profit. It’s much easier to focus on one number being the Overheads rather than getting too bogged down in all of the numbers listed. If you don’t have a budget it can be very difficult to know if overheads are reasonable anyway. Very few businesses have a budget, which makes it difficult to know how they are going during the year. If you are trying to reach a goal in business then you need a budget. Not having a budget in business is like trying to find a new destination without a roadmap.
This is the number of days, on average, your customers are taking to pay invoices. Managing this number can have a huge impact on cash-flow. If for example your Accounts Receivable Days is currently seventy and you can get it down to say fifty, you could be putting tens of thousands of dollars back into your bank account. The way to improve this number is to focus attention on your Accounts Receivable and Debt Collection procedures. It’s fine to look at the report out of your accounting system which lists all the customers and how much they owe you. If your business is growing rapidly you need to know how much, Accounts Receivable Days are changing compared to Revenue growth. This is because if it’s not comparable you will experience cash-flow squeeze and could run out of working capital.
This is the number of days, on average, you are taking to pay your suppliers. This number is just as important as Accounts Receivable Days in that it can have a big impact on your working capital situation. It is so easy in business to oil the squeaky wheel and pay suppliers who hassle you for money (sometimes before it’s due). It’s also easy to ignore potential better terms to be had from suppliers because you get so focused on Revenue. Some small changes to procedures relating to Accounts Payables can pay big dividends in your bank account. If your business is growing this could be critical cash for funding growth. I’m not suggesting stringing out suppliers beyond the agreed terms, but negotiating better ‘agreed’ terms for your business.
This is the number of days, on average, that goods for sale are sitting in your store-room, from when they are delivered by suppliers, to when they are shipped out to customers. These goods often have to be paid for before they have been sold. This means you have had to spend valuable working capital to have the stock sitting there waiting to be sold. If you can manage this situation better, and reduce the number of Inventory Days, this can have a big impact on your bank account and working capital situation. It’s very tempting when a salesperson calls and offers you a discount to buy more stock. It’s useful to consider the amount of working capital that will be tied up in that stock, compared to the discount being offered. If you are borrowing funds it’s also important to consider the amount of interest payable on those funds tied up in slow moving stock. If you are in a service based business Work in Progress (WIP) Days is very similar to Inventory Days, in that your ‘stock in trade’, is the labour and materials you have to sell. Slow WIP days can be just as dangerous to cash-flow and working capital as Inventory Days. Anything you can do to tighten up processes and speed up the time work is ready to be invoiced, will pay dividends in your bank account and reduce your interest expense.
One more thought about the Seven Key Numbers .. Of the seven numbers, four are calculated from the Profit and Loss Statement and three from the Balance Sheet. How many business owners look very closely at the Balance Sheet? Scary thought!