Use financial ratios and key performance indicators to track progress.
Knowing your numbers is crucial to being a successful business owner. Financial ratios and key performance indicators (KPIs), which are a measure of employee performance, can be used to gauge your company's overall financial health and make informed business decisions.
Many types of financial ratios can be used, but some of the most popular are profitability, solvency and efficiency. Profitability ratios judge a company's ability to generate a profit. Solvency ratios gauge how easily a company can pay its bills. And efficiency ratios analyze how well a company uses its working capital.
All companies should pay attention to several key ratios including quick ratio, cash to current liabilities, collection periods, sales to inventory, gross profit and sales per employee. And specific ratios should be used for key business segments.
Most KPIs and financial ratios are calculated using information from your income statement and balance sheet. Good industry-specific accounting software will do the calculations for you and warn you of problems.
Keep in mind that financial ratios and KPIs will mean nothing if your company does not practice quality, timely and accurate bookkeeping. With a careful compilation and analysis of KPIs and ratios, you will be able to manage your business by the numbers.
Key Performance Indicators
This is the amount of hours that were paid but not billed to a job. A service department should bill out at least 40 percent of its total labor hours while construction should be at least 90 percent.
Average Amount Per Invoice
Your goal for this will depend largely on your industry and the type of work you do. Be sure to set standards for your service and installation department.
Conversion Rate to Repair
This KPI indicates how many service calls (trip charges) were made versus how many of those trips resulted in an actual billable repair.
Conversion Rate to Service Agreement
This indicates how many service calls were made versus how many resulted in the sale of a service agreement. If you are in the service business, you should have approximately 300 service agreements per billable employee.
Your gross profit is the net sales minus the cost of goods and services sold (direct expenses). Service work should yield a gross profit of 70 percent or higher, while heavy construction can be 20 percent. One of your manager's most important responsibilities is to protect profit margins on labor and materials.
A callback is a return visit to correct an improper repair that cannot be billed. A good service department should have less than two percent of its service calls result in a callback.
Return on Sales (Net Profit Margin)
Definition: A ratio widely used to evaluate a company's operational efficiency. ROS is also known as a firm's "operating profit margin".
Recommendation: 5 percent or greater
Formula: (Net Profit Before Taxes/Net Sales) x 100
Return on Owner's Equity (Return on Investment)
Definition: A ratio that measures the ability to realize an adequate return on the capital invested by the owners.
Recommendation: 25 percent or greater
Formula: (Net Profit Before Taxes/Net Worth) x 100
Return on Assets
Definition: This ratio matches net profits after taxes with the assets used to earn such profits. A high percentage rate can show if a company is well managed and has a healthy return on assets.
Recommendation : 15 percent or greater
Formula: (Net Profit After Taxes/Total Assets) x 100
Acid Test (Quick or Liquid Ratio)
Definition: A ratio that measures the extent a business can cover its current liabilities with those current assets readily convertible to cash.
Recommendation: 1.35 or greater
Formula: (Cash + Accounts Receivable)/Current Liabilities
Cash to Current Liabilities
Definition: This ratio measures a company's ability to handle an absolute worst-case scenario when liabilities must be satisfied immediately.
Recommendation: A ratio of 1. In other words, you should have $1 in cash to pay off $1 of liabilities.
Formula: Cash/Current Liabilities
Sales to Total Assets
Definition: This measures the percentage of asset investments required to generate the current annual sales level. If the percentage is abnormally high, it indicates a business is not aggressive enough in its sales efforts or that its assets are not fully used. A low ratio may indicate a business is selling more than can be safely covered.
Recommendation: A ratio of 5 to 7.
Formula: Net Sales/Total Assets
Sales to Inventory (Inventory Turnover)
Definition: This ratio typically applies to companies that rely on inventory to help create sales. When this ratio is high, it may indicate that sales are being lost because the company is under-stocked and/or customers are buying elsewhere. A low ratio may show there is not a lot of demand for what you have in stock.
Recommendation: A ratio of 6 to 8.
Formula: Annual Net Sales/Inventory
Collection Period (Average Age of Accounts Receivable)
Definition: This is helpful in analyzing the collectability of accounts receivable or how fast a business can increase its cash supply. While each industry has its own average collection period, more than 10 to 15 days over terms should raise concerns.
Recommendation: 40 days or less.
Formula: (Accounts Receivable/Sales) x Days in Period
Sales to Total Labor Expense
Definition: This number indicates how much of your total sales revenue is consumed by payroll and labor-related expenses. The lower the number, the better because it suggests you efficiently use employees to create and manage sales.
Recommendation: A ratio of 0.3 or less.
Sales to Technician (Field) Labor
Definition: This ratio indicates how much of your total sales revenue (income) is consumed by payroll and labor expenses related to the field (usually sales, technicians and installers). A low number for this is also better because it suggests that you effectively use employees to create sales.
Recommendation: A ratio of 0.2 or less.
Formula: Field Labor COGS/Sale
Construction Business Owner, June 2011