The doctor says your business is going to live

A follow up to, "Doctor, doctor, give me the news"

Our last article had a tongue in cheek title of, “Doctor, doctor, give me the news”. The title was referring to the information you can get from your business in conjunction with your financial statement, be it a monthly, quarterly, or annual financial statement. (On a side note, we do hope you, or your accountant, are preparing monthly financial statements – the statements are that important.)

More importantly with this information is what you learn about your business when you perform these calculations and what you decide to do as a result of knowing that information.

Having taught financial information to my fellow retailers for many years, the question that always comes is, “What should my numbers be?”

There are two answers to that question. The first answer is relevant only if your business owes a lender – individual or lending institution – money; More on this answer in a minute.

The second answer is a simple, “better than the last time you performed this calculation”.

While you may find someone, perhaps an accountant, who will tell you what the industry standards are, you do need to look behind the numbers to see how the numbers were collected. As an example, an industry in retail that I have worked with over the years used to produce an annual report. If you collected the reports for several years, you would see that the “answers” varied a lot from year to year.

These variances happened for several reasons; which businesses were answering the questions varied from year to year; the size of the group varied; you are not assured those answering the questions are telling the truth; and you are not assured those answering the questions know how to perform the calculations correctly.

That first answer about the lender? When borrowing money, the formal loan document is more than an I.O.U. as you will see by the length of the document. The many pages are referred to as the “loan covenants”. These are the rules of how you will operate your business for as long as you owe money to the lender.

The loan covenants are going to specify which calculations about your business are going to be monitored and what the minimum acceptable number will be for your business.

Is this important? Yes, as your loan covenants also state that if you do not keep the business within the covenants there are several things that can happen to your loan and none of them are good. The first is you would find the interest rate of the loan would increase. A second possibility is that the loan which may be renewable is no longer renewable.

The third possibility is the lender is going to demand to be paid in full within a certain number of days. The loan covenants likely state you are going to provide the lender with your financial statements on a predetermined frequency.

Can the lender do that? Take the time to read through all the loan documents and see what all you have agreed to. That is why you should have your accountant and attorney read through the loan document before you sign. And while their answer might be, “this is just a standard loan document”, this is why you need to understand the loan document, what are the loan covenants, and what is the number the lender is going to expect to see.

Regardless of whether or not there is a loan, we offer these as the most important key performance indexes (KPI) for your business.
Want an idea of how well your business can pay the bills over the next twelve months? The current ratio is the measurement that will help with that.

Your balance sheet is divided into assets and liabilities. The assets are what the business owns. This is inventory, fixtures, equipment, perhaps a building, vehicles and cash. The second section is your liabilities; the amounts of money your business owes.

Within both, the assets and liabilities, they are also divided into two sections; current and long term. Current assets are those which you expect to convert to cash in the next 12 months. The long-term assets (also called fixed assets) are those not expected to be converted to cash in the next 12 months. Examples of these fixed assets would be the building you own as well as the fixtures and equipment.

Liabilities are determined in a like manner. The bills to be paid in the next 12 months are current liabilities and the rest are long term liabilities. Pay close attention to those liabilities which are mortgages or loans. Only the principle part of the loan that is to be paid in the next 12 months is a current liability. The rest of the principle due is a long-term liability. The interest part of a payment is a liability only if the payment is past due.

Back to the current ratio; Compare the current assets to the current liabilities. You are looking at what you expect to receive in cash in comparison to what you expect to pay. Definitely you want the current assets to be more. As this KPI is defined as a ratio, if you have $100,000 in current assets and $50,000 in current liabilities, your current ratio is 2:1.

For the majority of businesses, the ability to pay bills is looking good in the coming year. The closer the ratio gets to 1:1 the more you should be concerned about the coming year.

You should expect a lender is going to monitor the current ratio; you should also monitor it with the updated financial statements we hope you are getting every month.

The second measurement a lender may be watching is the acid ratio. The math for the acid ratio is the same as the current ratio with one difference; the current assets do not include inventory.

With most businesses, the inventory is the biggest asset you have. The only exception is usually the business that is located in a building they own. With the acid ratio, you should expect the lender is looking for a number that might be 1:1 or perhaps even less.

Without your business having a loan, if you choose to watch only one of these ratios we are going to suggest your monitoring the current ratio. The key to the ratio is its ability to get you a solid insight to the next twelve months.

The next KPI we expect a lender to be watching is referred to as the Debt to Equity Ratio. The name of the ratio gives you a clear understanding of how much debt the business has in comparison to how much equity the owner has in the business.

Equity is another way of stating how much of the business belongs to the owner. Equity could also be stated as “net worth”. The lender is wanting to watch this number because in the event of a problem with the business, the lender is expecting the more equity the owner has, the less likely they are going to just close the business and walk away.

If an owner closes the business and has a “going out of business” sale, that owner is less likely to recover the equity they have in the business. Note the ratio is stated as “debt to equity”. You want the larger number to be on the right side of the ratio showing the owner has more equity than the business owes.

Looking at debt and the business, we frequently find business owners confusing business debt and personal debt. Perhaps an owner has taken a personal financial class; the name of Dave Ramsey frequently comes up.

While the logic in personal financial classes is to not have debt, this logic does not transfer to business. Consider a bank that will loan money to a business at a 6% interest rate. When we get to the last calculation in this article, we are determining what is the rate of return you get on your money in the business. What if your business gets a 20% return on the investment? Why wouldn’t you borrow money at 6% if you could make it return 20%?

We have three additional KPIs that we are not expecting to see in a loan agreement. However, a good accountant is going to be watching these and as the owner of the business, you should be carefully watching these also.

The first is the Inventory Turn Rate. We mentioned many businesses having inventory as their biggest asset. The measurement that tells you if your inventory is driving profit to your bottom line is that of the turn rate. Inventory turn is telling you how many times over the course of the year you are selling that inventory. Using quantity as an example, if you buy a dozen at a time of an item and sell one each month, your turn rate is 1.0 because you sold your inventory once.

However, if you bought only two at a time (the proverbial “one to show and one to go”), you are going to be buying inventory more frequently over the course of the year. Your inventory is going to be higher. This means money is not sitting on the shelf for many months.

While the inventory turn rate can be calculated at cost or retail, we will explain the cost method. Take the cost of goods sold for a twelve month period. This number appears on your year end profit and loss statement. The second step is to take the amount of inventory from each of the twelve balance sheets in the same period; add the inventories together and divide by twelve to get an average inventory.

Now divide the cost of goods sold by the average inventory and you have inventory turn rate.

Simply stated, the higher you can move the inventory turn rate without losing sales by not having inventory, the more profit you are going to drive to the bottom line.

Days of inventory on hand gives you another idea of how well you are moving inventory. Start again with the cost of goods sold from the last calculation and divide by 360. While it is not the 365 days of the year, and does not consider how many days of the year your business is open, the resulting answer is how many days of inventory you have. The smaller the answer, the more you are turning inventory as well as being an indicator that your inventory is fresh.

The last KPI we are going to examine is one the lender will not likely look at, but is definitely one you want to know. How well is the money you have in your business providing a return for you. If you took all of your equity and were to invest it with a stockbroker, you would ask what you could expect for a return on your investment.

You should be asking the same question of your business. The Return On Investment is that calculation. It is definitely the most complicated calculation, but is worth the effort to know how well you are doing. Because the calculation has multiple factors and would take a lot of words to explain, we offer an easier solution by inviting you to visit: Return on investment and enter the information from your business.

Note that none of the information you enter is retained by the website, so your information remains private. This calculator is very useful because of how you can use it to learn. We suggest you enter the information from your current financial statement to get what is the return on investment now.

Then begin to change numbers. We suggest starting with changes to margin or operating expenses. You will see each of these will improve your ROI. Then change your average inventory on hand. Reducing your average inventory on hand means you are increasing your inventory turn rate; a KPI we have already outlined.

You will likely be very impressed to see that an improvement in your inventory turn rate is going to greatly increase your ROI.

As a closing thought; do not ignore this information. Do not say your accountant watches the numbers for you. This is your business and no one is going to have a need for the business to succeed as you do. And, no one other than you can do the job of being the owner.

If you would like to send this article to someone you know, please use this form to forward this page:

Your Name:	E-Mail:
Friend's Name:	E-Mail:
	Security Code: