When we get sick, we take our temperature and inventory our symptoms, then seek medical advice when necessary. Some of us even receive routine physical assessments when we lack symptoms to detect and treat underlying problems that could sideline us in the future. In the same way, business owners should periodically assess the health of their business. Detecting shortcomings or potential concerns early provides time to change course or reduce the impact. And uncovering the strengths of your business provides valuable information for allocating time and business resources wisely so that you get the greatest returns.
One way to check the health of your business is to look at financial metrics that can reveal underlying problems with cash management, expenses, pricing or capital.
Is It Time For a Business Health Checkup?
“Truly understanding those metrics and gauging your performance against competitors using benchmarking data can give you a clearer picture of both strengths and areas that need fresh attention,” said Brad Schaefer, an analyst with Sageworks, a financial information company.
Below are key financial metrics that can help you understand your business and how you’re faring against peers, according to Schaefer. If you have an accountant or someone preparing financial statements or tax returns for you, they should be able to provide you these metrics easily and give you additional context as well. If you’re doing your own analysis, you can use this glossary of financial terms to help you see how these metrics are calculated. In addition, average values for each of the metrics, derived from Sageworks’ analysis of financial statements in its database, are shown in the chart.
Accounts Payable Days and Accounts Receivable Days
These ratios help show how you’re managing the company’s cash position so that at any point in time, you have enough to cover commitments.
“Accounts payable days can indicate whether you’re paying your suppliers too quickly,” Schaefer said. “That’s money you could be investing instead of distributing immediately. “
Accounts receivable days, on the other hand, can alert you when you’re not receiving payments from customers quickly enough. Generally, lower numbers are better, but this varies by industry. For example, some industries routinely give customers a 30-day grace period for payments. Other industries don’t get paid until the entire job is complete, so some types of construction contractors have an average accounts receivable days ratio of 65, while child day care operators’ average AR days ratio is about 3.
This ratio measures the number of days it takes to move inventory, but it is very specific to the industry that is being evaluated. Restaurants’ products have a short shelf life relative to a clothing store’s merchandise. The average privately held restaurant in Sageworks’ database has an inventory days ratio of 13, while it is 177 for clothing stores. Generally, lower numbers are better, because you want to turn over as much inventory as possible in a year.
Pre-tax Net Profit Margin
Probably the most important metric, this tells how much profit you get to keep from each dollar in sales. “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 your company’s revenues,” said Schaefer.
Current Ratio and Quick Ratio
These two metrics give you an idea of your liquidity, or how well you can meet your near-term obligations, and they are most helpful when analyzed together. “If the business does not have decent liquidity, then one unexpected expense could severely hurt it,” Schaefer said.
Current ratio 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 includes inventory in the calculation, so it may provide a distorted understanding of the company’s very short-term cash flow, Schaefer noted.
The quick ratio shows that shorter-term view.
Because all of these metrics can vary by type of industry, it’s difficult to make sense of financial ratios unless you find quality benchmark data. 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.
By Mary Ellen Biery, Research Specialist, Sageworks
Sageworks, a financial information company, collects and analyzes data on the performance of privately held companies and provides accounting and audit solutions.