May 25th 2012
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By Mary Ellen Biery, Research Specialist, Sageworks Inc.
Is your business successful? How do you know?
If you're like most business owners, your days are filled by efforts to make your company successful. Those tasks might be focused on making a great product, generating sales, or building customer relationships. And you might be great at those things.
But how great are you at making money? And how well are you managing your resources?
Pre-tax net profit margin. This metric is probably the most important, because it tells you how much profit you're making from every dollar in sales. For private companies, it's usually expressed as net profit before taxes in a given financial period divided by sales.
"A higher margin, or higher profitability, is better for a company's profit picture," said Brad Schaefer, an analyst with Sageworks Inc., a financial information company that provides financial analysis and benchmarking applications to accounting firms and private companies. "This number can show you how effective you're being with expenses and if you should decrease certain expenses so that they don't eat up as much of the revenues."
Current ratio and quick ratio. These two metrics are considered fundamental liquidity ratios, or ratios that give an idea of how well you can meet your obligations, and they should generally be analyzed together. "If the business doesn't have decent liquidity, then one unexpected expense could severely hurt it," Schaefer said.
Current ratio is expressed as current assets divided by current liabilities. It basically shows whether the assets that you can convert into cash quickly (within a year) will cover what you must pay off soon (in less than a year). A ratio of less than one means you could run short of cash within the next year unless you generate additional cash. But the metric has some limitations, Schaefer noted. "For example, by including inventory in the calculation, it may provide a distorted understanding of the company's very short-term cash flow," he said.
The second liquidity ratio is the quick ratio, which is typically expressed as cash plus accounts receivable divided by current liabilities. Again, the quick ratio may not be perfect for gauging liquidity, but it's a useful and popular metric to pair with the current ratio.
Accounts payable days and accounts receivable days. Accounts payable days and accounts receivable days are also key, Schaefer said. "Owners can discover that they may be paying their suppliers too quickly, which is money they could be investing instead of distributing immediately, or they could find they're not receiving payments quickly enough from their customers," he said.
Accounts payable days is expressed as accounts payable divided by cost of goods sold multiplied by 365 days. What's a good accounts payable turnover ratio? It varies by industry, but generally, higher numbers are better.
Similarly, accounts receivable days is expressed as accounts receivable divided by sales multiplied by 365 days. Lower numbers are generally better. But this, too, will vary dramatically by industry. For example, some industries routinely give customers a thirty-day grace period for payments, especially those that bill for services, and other industries don't get paid until the entire job is complete. So construction companies, for example, have an average accounts receivable days ratio of more than sixty, compared with retailers' average accounts receivable days ratio of about twenty, according to data from Sageworks.
Because of this variation, Schaefer said, it's tough to make sense of financial ratios unless you find quality industry data against which to benchmark your company. What is a good net profit margin? What are sound liquidity ratios?
"Without comparing your own business to others, how will you know if an account receivable days of fifteen is great, average, or high?" he said.
Knowing how your metrics compare to other companies also helps you identify business areas that need fresh attention, Schaefer said.
Trade groups, surveys, and information providers are among the resources for finding benchmarking data. The important thing is to find businesses of a similar industry, revenue size, and geographical location.
"Business conditions can vary greatly between different areas of the nation, even if the companies are the same size and they make the same products," Schaefer said.