Advivo Partner, Chris Morris, shares his tips on how to effectively check up on your business.
This article is written for those who are in business already, understand general business terminology, and would like to learn about some simple tools which can be used to check up on how their business is travelling to ensure it’s able to continue to achieve the desired results.
1. Monitor your Gross Profit Margin
Regardless of which industry you’re in, you will still be able to measure your gross margin by identifying your direct costs and your net sales. Gross Profit Margin is simply the percentage of profit from every sale, before overheads are subtracted. The formula is:
Gross Profit Margin = (Net Sales – Cost of Goods Sold) / Net Sales
This is a key metric to understand because it can be used to calculate your Break-Even Point (BEP) which tells you what level of sales are required to ‘Break-Even’ after all direct costs and overheads have been paid. It also allows you to work backwards to calculate what level of sales are required to meet a desired amount of net profit.
Gross Profit Margin is an important metric to monitor because as costs increase, your gross profit margin could be eroded if not monitored and maintained correctly and erosion of gross profit can cause significant issues for the profitability and longevity of any business.
There is no ‘correct’ Gross Profit Margin to suit every business. This is because it depends on whether you’re selling products or services, as well as the type of sales strategy in place. Regardless, once a gross profit margin has been identified and understood for a particular business, a target can be set and monitored for variances to ensure necessary adjustments can be made.
2. Monitor your Current Ratio or Quick Ratio.
This is another key metric to understand and regularly monitor because it provides an indication of liquidity, which is the ability for a business to pay its current debts. The current ratio simply compares all the business’s current assets to its current liabilities, and a good rule of thumb is that your current ratio should ideally be greater than 2:1. The current ratio can be calculated as follows:
Current Ratio = Current Assets / Current Liabilities.
A more stringent liquidity measure for a business is the Quick Ratio. While the current ratio is calculated using all the current assets of a business, the Quick Ratio is calculated using only those current assets that can quickly (within 90 days) be turned into cash. A key difference between the two is that inventory is included in the Current Ratio but is excluded when calculating the Quick Ratio. A Quick Ratio of greater than 1:1 is preferred.
Quick Ratio = (Cash and Cash Equivalents + current receivables + short-term investments) / Current Liabilities
A downward trend in either your Current Ratio or your Quick Ratio could indicate a tightening of free cash flow in the future and such a trend should be understood so as any corrections can be made as appropriate.
3. Check up on your business strategy
The business environment is constantly changing and there are many factors which can negatively impact the results of even the best businesses.
It’s good practice to regularly check up on your business strategy from a high level, before diving into the detail of what’s being achieved. Steven Covey anecdotally refers to a team of tree loppers clearing spaces in record time, thinking that they’re doing fantastic, until they find out that they’re clearing the wrong jungle. I love this analogy because it’s a great reminder that we need to remove ourselves from the daily detail regularly, to ensure that we’re still heading in the desired direction and furthermore to ensure that the desired direction still makes sense. There are some great tools such as a Strategic SWOT Analysis which can be used to ensure you’re keeping up and best positioned to take advantage of the current and future business environments.
These are just my top three tips. There are many more which could/should be utilised as well, depending on a specific business and the challenges it faces. If you would like to learn how these or other tools could be used to help monitor the progress of your business, please don’t hesitate to contact us today!
Written by Chris Morris
Partner – Advivo Business Advisors and Accountants.