| It is fairly
easy, when you’ve seen an opportunity, to set up a business
to exploit it, and to do quite well for a couple of years.
Difficulties often come when continuing beyond that or when
trying to expand.
Sometimes the reason is that the opportunity was one that
was only ever going to be short-lived. More frequently, however,
business owners move from day to day without a long-term plan,
or, if they have a plan, without any way of measuring their
progress against it.
In this situation the problem lies in knowing how to measure
progress – instinct and gut feeling are notoriously
faulty. Yet, whatever your business, it is not only possible,
but quite easy, to assess the health of your business by using
a simple set of measurements called key indicators.
What are key indicators?
Key indicators are a handful of figures that allow you to
measure your progress by quantifying the essential elements
of your business. They fall into two categories:
- Key operating indicators, which demonstrate how well the
different aspects of your business are working.
- Key strategic indicators, which demonstrate how well you
are progressing towards your goals.
Both these can be split further into tangibles, such as sales
and growth rate, and intangibles, such as customer satisfaction.
Key objectives can either be ratios (for example, stock/turnover);
percentages (growth in sales over last quarter); rankings
(market position); or absolute figures (number of customer
complaints).
The three steps to monitor your business’s
health
- Identify what you want to measure from your business plan.
Look at your business plan and extract from it a verbal
statement of your aims. Known as a ‘strategic objective’
statement, it will say something like this: ‘Within
the next five years, Bloggs Widgets will become one of the
top three widget manufacturers in the UK, with a high level
of customer and staff satisfaction. Turnover will rise to
£2.5million, with a gross margin of 30%’. (If
you don’t have a full business plan, preparing such
a strategic objective statement is the one of the best ways
to start the process.)
- Divide the objectives into tangibles and intangibles.
In terms of the strategic objectives statement above, the
elements of staff and customer satisfaction are intangibles,
while market position, turnover and gross margin are tangibles.
These can now become your key indicators along with a number
of standard ratios.
- Work out how to measure your key indicators and create
a system for doing this at regular intervals – ideally
at least once a quarter. For the tangibles, this is merely
an extension of doing your accounts and can even be done
automatically by using some standard ratios. For the intangibles,
you will need to devise a system of quantifying them.
Measuring tangibles Some of the things
you might want to measure include:
- Sales.
- Number of outlets.
- Group and outlet turnover and profits.
- Profit/square metre for each outlet.
- Profit per employee.
- Number of referrals and percentage converted.
- Percentage of repeat buys.
- Number of employees and employee turnover.
- Growth rate.
- Website activity and resulting sales.
Some tangibles, such as turnover or total sales, are easy to
measure: you just identify a figure in your accounts. Others,
such as profit per outlet, or even profit per square metre per
outlet, are also easy enough to find once you’ve set up
a system that allocates income and expenditure into cost and
profit elements.
For others, you need to work out some simple ratios. Such
ratios fall into three basic types:
- Liquidity ratios, which measure your ability to meet your
expenses.
- Profitability ratios, which measure how well you are doing.
They also help you to plan change by highlighting the need
for higher sales, bigger margins or lower costs.
- Efficiency ratios, which help you assess your stock levels,
asset management, use of borrowing and all the other aspects
of how you actually manage your business.
If you produce your accounts in an accounting package, most
of these figures will be produced automatically. In other cases,
you will use the figures in your profit & loss account,
balance sheet and other reports as the basis for financial calculations.
Note that some of the ratios in themselves can mean little.
Their true value often lies in comparing them over time and
identifying trends. Another huge benefit is benchmarking,
where you compare your key ratios with those of similar businesses.
Healthy ratios for your type and size of business are developed
from industry averages. You can then see where you are weak
and need to focus, or strong and can exploit it.
Liquidity ratios
The main liquidity ratio is called the quick ratio or acid
test. This shows the business’s ability to meet its
current liabilities with the money it has readily available.
You should exclude stock from the calculation because this
is notoriously hard to sell quickly and to do so, you may
have to drop the price considerably.
- Quick ratio = (current assets – stock) ÷
current liabilities
So, if your current assets on your books are £13,000,
your stock is worth £3,000 and your current liabilities
are £5,000, you have a ratio of 2:1. If the ratio were
the other way round, at 1:2, you could be in trouble if all
your creditors demanded payment instantly.
Profitability ratios
Return on equity (sometimes called return on capital employed)
is the profit you made in the year, expressed as a percentage
of the capital invested in the business. This is generally
considered to be one of the best ways to test your profitability
and answers the simple question: ‘Am I actually making
more from my capital than I would by investing it on the stock
market?’
- Return on equity = net profit before tax ÷ net
worth* x 100
(*on your balance sheet, the difference between your assets
and liabilities)
For example, for a company with net profits of £52,000
and a net worth of £129,000, the return on investment
would be 40.3%. This is an excellent return compared with
the same capital invested in the stock market, which might
yield around 8%.
There are two other important profitability ratios that you
want to watch – gross profit margin and net profit margin.
(Most accounting packages will automatically produce these
figures for you.) These should remain reasonably constant
or, ideally, improve as you become more efficient and drive
down costs. You should investigate carefully sudden leaps
either way.
The gross profit margin shows the average profitability of
your sales. It shows how much profit is left from each sale
after taking off the direct costs of production – such
as stock used. The average figure will vary from industry
to industry.
- Gross profit margin = gross profit* ÷ sales x 100
(*Gross profit = sales – cost of sales)
For example, for a company with a gross profit of £92,000
and sales of £138,000, the gross margin would be 67%.
The net profit margin shows how well you are doing as a business
overall, taking into account the level of overheads against
sales.
- Net profit margin = net profit (before tax)* ÷
sales x 100
(*Net profit = sales – total expenses)
For example, for a company with a net profit of £52,000
and sales of £138,000, the net margin would be 38%.
Again, the average figure will vary from industry to industry.
Many people would like a very high figure for this, but most
businesses earn a net profit margin of under 10% and are quite
successful.
Efficiency ratios
There are several useful efficiency ratios, some of which
are explained below.
Income and expense ratios allow you to check trends easily.
(Most accounting packages will automatically produce these
figures for you as a percentage of sales or turnover.)
- Salaries ratio = salaries ÷ sales x 100
For example, say your salaries were 22% of your turnover this
year, and 14% last year. You may have hired extra staff who
are having little real effect on your growth, in which case,
you would want to know why.
Equally, if your widget sales accounted for 76% of your turnover
last year and only 62% this year, you would want to know why.
Return on sales
- Return on Sales = gross profit per product or service
÷ sales x 100
For example, a company sells £85,600-worth of widgets
which cost £32,400 to produce, so its gross profit on
widgets is £53,200. The total sales are £138,000.
The return on sales for widgets would be 39%.
You may find that some products or ranges produce much better
returns than others, so perhaps should be pushed harder. Or
it may emerge that overall profitability depends upon more
than producing and selling widgets – high customer satisfaction
may, in fact, be rooted in the quality of the widget servicing
you give, and the amount customers are spending with you on
servicing won’t show up in the widget sales figures
but in your servicing sales figures.
Stock turnover ratio is important efficiency ratio. It shows
how quickly you move your stock on average. Put another way,
it calculates how many days on average you hold stock.
- Stock turnover = stock value ÷ sales
- Days on hand = 365 days stock ÷ turnover
Say your stock is worth £50,000 and you have annual sales
of £200,000 – you get a turnover figure of 4 times
a year. If you do the next stage of the calculation, you have
a days-on-hand figure of 91 days. Dependent on the industry
you are in, a stock turnover ratio of 4 might be low (compared
with the generally accepted desirable ratio of between 6 and
7) and may indicate too many obsolete items in stock, overstocking
of certain items, or an unrealistic determination never to be
out of any item of stock. This means you are tying up too much
vital working capital that could be better used for, say, marketing.
Like other ratios, stock turnover is most valuable when considered
on separate product lines rather than on your total stock.
One big American supplier of car parts clung to their slogan
of ‘We are never out of stock’, which they interpreted
to mean ‘You can walk into any of our stores anywhere
in the country and get any part straight off the shelf’.
This meant that they had a nationwide stock inventory which
included several hundred large items such as replacement engines
and gearboxes, when they never sold more than a couple of
dozen a year. When they realised this, they changed their
slogan to ‘Never more than 24 hours wait’, kept
the local stores stocked with rapidly moving items, and kept
the big items in a few special stores close to ‘hub’
airports where they could be sent to customers within a few
hours.
Average collection period
The average collection period ratio works in much the same
way, in that you are looking to see how many days it takes
for debts to be paid on average.
- Average collection period = total debtors x 365 ÷
sales
If your stated credit period is 30 days, a figure of between
40 and 45 is generally considered acceptable. Anything higher
either means you might have problem debtors or a poor collection
system. Anything lower means your collection system is excellent
– or maybe that you are offering too high a discount
for rapid payment!
Quantifying intangibles
Not all indicators can be neatly calculated, particularly
intangibles. However, that does not mean they are less important
to monitor.
What counts as an intangible? This varies from business to
business, and includes such things as customer and staff satisfaction,
professional standards, being at the leading edge of your
industry, operating in a systematic way, and some other factors
such as goodwill. You can’t measure these things, but
you can quantify them in the same way sports judges quantify
a gymnastic performance – by awarding marks on a scale
of 0 to 10.
In competitive sports, 10 is the best possible performance,
0 is the worst (in sports terms, it means no performance at
all). In a business context, however, it is sometimes possible
to have a performance that is worse than nothing (a branch
not only doesn’t make a profit, it actually costs you
money to keep it open) so you might want to operate on a scale
of -10 to +10.
Take ‘staff satisfaction’, for example. If your
staff never went sick, were always reluctant to take holidays,
did more than their official hours and never asked for overtime
pay, and were always smiling, you might be able to award your
business a figure of +10. If they were frequently off sick
for minor ailments, consistently late and looked permanently
miserable, you might award a figure of -10. Probably your
actual figure will be somewhere in between, and your target
may not realistically be +10. But you would still need to
track your progress towards that ideal situation. So just
like the tangibles, you need to make your assessments at least
quarterly.
You simply write down the best and worst scenarios at either
end of the scale, and make an honest judgement. Ideally, get
an independent assessment of some measures, either from those
affected or from an outside observer, rather than trying to
judge them yourself. Hence, run a quarterly customer satisfaction
survey or call in a quality consultant.
Create a tracking system
For both tangibles and intangibles, the easiest way to track
your progress is to set up a spreadsheet as follows:
Indicator
Target
Last quarter
Current quarter
Progress
Sales
Gross profit margin
Stock days on hand
Etc.
The map is not the territory
Maps are wonderful things and, to the person who knows what
they signify, they are full of information – but they
are not the same as crossing the country on the ground. A
set of contour lines shows a gentle slope but not that the
slope consists of slippery rock with intermittent holes full
of rattlesnakes. And it’s just the same in business.
Business plans and key indicators are not the whole reality.
In the context of working out how your business is doing,
this means you need to look at your key indicators regularly,
and you need to understand that where intangibles are concerned,
putting a performance figure on them doesn’t necessarily
make them tangible. It has just given you a way to assess
them that is more meaningful than gut feeling.
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