Hawke’s Bay’s economy is booming. The region is experiencing growth across a range of sectors and industries, unemployment numbers are dropping, house prices continue to rise and there seems to be an air of business confidence within the region which is encouraging business owners to look to their future and what opportunities these positive developments could bring. One of these opportunities is an increase in business investment which is exciting for both established and developing businesses. With that said, it is important that you have a clear understanding of your business fundamentals so that if opportunity comes knocking, you are in a solid position to best understand the offer on the table. Below we focus on four financial ratios that should be monitored on a monthly basis.
Gross margin
Measured overall and at product level, this formula measures the amount of margin each dollar of sales is contributing toward overhead costs and profit. The result is found by dividing gross profit (subtract cost of goods sold from sales) by sales. A 40% gross margin means that for every $100 of sales, $40 of gross margin is generated to cover all other costs and profit.
Unless you are offering customers a discount, or incurring additional direct costs, your gross margin shouldn’t change whether your sales increase or decrease. We often hear business owners say “I am chasing an increase in sales”, to which we would add “provided you maintain your gross margin”. If sales increase but your gross margin decreases (perhaps as a result of increased commission or discounting), you may be working harder for each dollar of sales but making less margin.
Profitability
There are many measures of profitability, including operating profit, earnings before interest, tax, depreciation, and amortisation, and net profit to name a few. Choosing a consistent measurement to monitor is important as well as an understanding of what is and isn’t included in that measure.
Net profit before tax is a measure of what is left for the owner after overhead costs have been deducted from gross margin. To find the net profit margin divide net profit before tax by sales. A 5% net profit margin means that for every $100 of sales, $5 of net profit is generated for the owners of the business.
If the owners of a business are not working owners, but are paid a salary, it can be more comparable to deduct their salary cost (or a proxy amount for which they would pay someone to manage the business) from overhead costs before calculating net profit margin. This is called “normalising” so that comparison of profitability can be made with other similar businesses or against industry benchmarks.
Profitability is negatively impacted by increasing overhead costs. Carefully reviewing each overhead item to ensure it is necessary and efficient can be a useful exercise.
Inventory turnover
Measuring how quickly your inventory turns over is a critical measure for many business owners where inventory (or stock) is a significant asset. Slow moving inventory can lead to lower gross margin through discounted selling price, obsolescence, and storage costs.
Inventory turnover can be measured in number of days, found by dividing average inventory value by cost of goods sold multiplied by number of days in the reporting period (e.g. 365 if reporting period is one year). A low number of days indicates inventory is selling quickly, however understanding your product mix is important as average inventory days vary widely across product lines.
Cashflow
Money in the bank or positive cashflow is a good indicator that business is going well. Many retail businesses are largely cash based operations, with customers paying for the goods at point of sale, and suppliers requesting payment shortly after delivery. This means that managing and reviewing cashflow is an essential skill for business owners.
Periods of high sale activity and strong cashflow can be followed by lulls which often coincide with GST and tax payment due dates along with fixed costs such as rent and employment expenses. This is particularly evident over the Christmas trading period for many retailers where high sale volumes during December are followed by significant cash outflows in January. Forecasting cashflow can help highlight these pinch points and enable you to plan accordingly. There are many tools available to assist business owners with cash forecasting, such as Spotlightand Futrli.
If your business is set to retain its competitive nature during this growth period and stay ahead of the pack it is vital that you plan ahead, and have a good level of financial literacy. Understanding the numbers is not just for accountants - as a business owner your success depends on your ability to measure the impact of external changes on your business and implement timely changes.