Part of the problem with financial statements is they do not tell the whole story, metrics wise. Each financial statement tells part of a story. One must put all of the statements together to get a better idea of what the full picture is. However, even then, it is easy to misconstrue what the data is saying.
There are short cuts for doing this in many cases. These short cuts enable an owner to interpret their financial statements quickly, which can help since many bookkeepers’ knowledge does not go past the basics. These short cuts come in the way of ratios and metrics.
Looking at a financial statement in a “vacuum” can be misleading. For instance, looking at an accounts receivable balance for a single month doesn’t tell you much compared to looking at the whole picture. It doesn’t tell you if collections are slow or if cash flow issues are occurring. For this, you need a different level of analysis.
Creating a Dashboard
Whether my clients are are an enhanced bookkeeping or outsourced CFO client, the first thing I do for them is create a dashboard. A big portion of these dashboards is ratios and metrics. Metrics should be analyzed over a period of time (just like financial statements).
Most business owners see metrics and run. And somewhat rightfully so. For years, owners have been force-fed ratios and metrics that have little to do with their businesses. Even worse, the accounting profession has done little to explain to owners why these metrics matter.
For most businesses, they should use ratios and metrics that are specific to their industry. For instance, the dashboards I build for my service clients looks very different than ones for my manufacturing clients. An essential metric measurement in the service industry is utilization. If possible, utilization is how much of an employees daily time can be charged as billable work. However, this metric doesn’t make sense to report in manufacturing.
There are four performance metrics and ratios that I believe are important for almost every business owner to review regularly. Below we will go into what each of these metrics are and what they represent.
Day’s Sales in Accounts Receivable
While it can be said that revenue is the lifeblood of every business, I would argue it is the collection of revenue that determines success. The collection of accounts receivable has one of the most significant impacts on cash flow for businesses.
A business owner needs to determine how quickly they are collecting their accounts receivable. Based on how quickly a business owner can collect accounts receivable, it will impact their credit term decisions, how much effort they put into collections, how quickly they pay their bills, and several other decisions.
The metric day’s sales in accounts receivables tells an owner, on average, how long it is taking to collect their accounts receivable. For instance, let’s say a business had $1 of sales every day ($365 in a year), and at a particular month-end, they had $30 in accounts receivable. The metric would show that they have 30 days of sales in receivables. In other words, it’s taking on average 30 days to collect their revenue.
Is 30 days good?
I don’t know. To answer that question, you must know how long historically it has taken to collect receivables. You might also want to know what the industry standard is. By reviewing this monthly, an owner can determine several things –
- Should they extend or reduce credit terms
- Do they need to put more efforts into collections
- Do they need to slow down paying vendors
- Are there potentially bad debts that need to be reviewed
Cash Flow From Operations as a Percentage of Sales
Net income is great, but it often doesn’t tell the whole story. From my point of view, the cash flow statement is the best way to review an organization’s performance.
Cash flow from operations is one of the three areas reported on the cash flow statement. Just like it sounds, it is the total cash flow generated or used in the everyday operations of the business. It excludes cash used or generated from investing and financing activity.
Reviewing this as a percentage of sales will tell an owner for every $1 of revenue recorded how much cash is being generated. Cash flow, like many other metrics, should be analyzed over a period of time.
Owners are amazed to learn that they may only be earning $0.05 for every $1 of cash generated. The ratio can go a long way in telling an owner how efficient their organization is.
Days Sales in Inventory
You should think days sales in inventory sounds familiar. The metric is very similar to days sales in accounts receivable. This metric will tell an owner, on average, how many days it will take to sell the amount of inventory on hand.
This ratio is computed by taking average inventory and dividing it by COGS. Once that is done, multiply the result by 365.
More businesses than I care to remember get in cash flow crunches from having too much inventory on hand. This ratio results in owners being amazed to find how many days it will take them to sell all of their current inventory on hand.
It is essential to have a semblance of what is normal throughout the rest of the industry. For instance, if an industry has a long manufacturing cycle, they will tend to have more days worth of inventory on hand. Separately, a retail concept such as a convenience store should strive to have 20-25 days worth of inventory on hand.
This is a metric that many owners find it helpful to take one step further. By computing days sales of inventory on hand at a product level, an owner can identify how quickly each product is moving. This might have an impact on discounts and deciding which products to carry overall.
Working Capital Ratio
Working capital represents a company’s ability to pay its current liabilities using its current asssets.
To calculate the working capital, a business owner would compare their current assets to its current liabilities. Current assets on the balance sheet include cash, accounts receivable, inventory and other assets expected to turn into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term deb due within 12 months.
Ratios Are Important
The working capital ratio can give a business owner an idea of if they will have issues satisfying their liabilities in the next 12 months. Having a negative working capital ratio can raise some red flags. However, by looking at this ratio regularly, an owner can make changes to their business to make sure they can meet their obligations.
As an outsourced CFO, the first thing I do for my clients is to help them understand the ratios relevant for their business and how to analyze them properly. Even with Krieger Analytic’s enhanced bookkeeping service, we review reports with our clients to make sure they are tracking key metrics.
Producing financial statements can’t be a check the box process for a business owner each month. For the statements to provide their real value, the owner must use them to help create strategies and other business decisions.
Above I have presented four ratios that almost all business owners should be using. Just using these four alone will help an owner create a “smart” financial and accounting process and give them a leg up on their competitors.
About Krieger Analytics
My name is Matt Krieger, and I am the founder of Krieger Analytics, an accounting and advisory partner for small businesses and franchisors. Our goal is to completely outsource your accounting department from bookkeeping and taxes to CFO advisory services. I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado.
As a small business owner with a background in finance and strategy, I realized the benefits that a CFO could bring to smaller organizations. Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO or bookkeeper. To better fit my clients, Krieger Analytics is a part-time resource. We partner with clients by coaching, giving them clarity into their business, and creating growth strategies. Conversations are free, so don’t hesitate to reach out to me at email@example.com.