Important Ratios for Your Busines

~ C.O.R.E. Beliefs ~ 1 Comment

Happy Friday.   In only a few hours, it is time for some Pinot Noir, rib eye, more Pinot, and perhaps a little Royal Painz.  I didn’t think I would like the show (it’s on Netflix) but if you would like to see a MacGuyver-esque doctor who makes housecalls, you may enjoy it. It is also Rose Parade weekend in Portland!   What plans do you have for this fun weekend?

I think a big part of why I enjoy accounting is that I get to see so many different things and work with so many different clients.  Each client is unique and yet so very much like every other business:

They have a “goal of making money now and into the future.” (the Goal by Eliyahu Goldratt).

Making money is the primary reason for being in business because at the end of the day, the Company must pay its bills and provide a return to the owners.  Anything less leads to the failure of the business.

I enjoy helping small business owners find ways to monitor how well they are doing in relationship to their goals and one area we spend quite a bit of time on is building key ratios and graphing them.  I then teach and help the small business owner’s staff complete the ratio worksheets and help explain what is shown on the graphs.

Below are a few of the ratios I think are very helpful to most small businesses:

  • Gross Profit per Labor Hour
  • Marketing Expense per New Customer
  • Website hits per New Customer
  • Website hits per Business Inquiry

Some of the ratios above are lagging indicators and some are leading – meaning that some measure how well the business performs (lagging) and some measure how new business comes in (leading).   Having a good mix of these measurements allows you to know quickly if your business is on track.

Naturally, these ratios assume that your accounting is current and you have developed ways to track the non-accounting data.  It also is very helpful to set an expectation for your business so you know if everything is running smoothly or if adjustments need to be made.

Examining each ratio:

Gross Profit to Labor Hour

I like this ratio as it essentially turns every business into a “service business” by ignoring the Cost of Goods Sold.  Gross Profit in a manufacturing business is essentially the amount of revenue available to pay the business and operating expenses.  By starting the calculation with Gross Profit instead of Total Revenues, you can measure the impact of your labor on generating the money to pay the bills and earn a profit.

Marketing Expense per New Customer

This ratio helps you understand what it costs you to attract a new customer to your business.  If you are spending $10,000 per month on marketing and attract on average 4 new customers, then the marketing expense per new customer is $2,500.  By knowing what the lifetime value of a customer, you can begin to ask if we are getting enough new business in the door and if we are effectively closing sales.

Website Hits per New Customer

As you transition your marketing efforts to online, this becomes a very important indicator of your marketing performance.  How many people come to your website and how many ultimately do business with you measures your site’s ability to educate and inform your prospects.

Website Hits per Business Inquiry

This ratio actually precedes the prior ratio by helping you examine your internet sales funnel at an earlier stage.  How many web hits actually end up with the reader clicking “I want to know more?”  You see that from this  initial click, the ratio Website Hits per New Customer has more meaning as  your chart can show the ratio between total page visits, total “interest” clicks and then number of new customers.

There are many different ratios that can help you manage your small business without having to get stuck in the details of your accounting system.  Talk with your accounting professional about ways to look at your business without having to interpret your financial statements and that can keep you focused on your Goal.  If you are not working with an accounting professional or would like to have a different set of eyes to help you, feel free to reach out to us at Currie & McLain.  We are happy to consult with you at no cost and no obligation and help you see your business in a new way.  And if you haven’t read the book, “The Goal” I highly recommend it.  It is a fun story, easy to read and provides new insight into other ways to manage your growing business.

 

 

The Financial Statement

~ C.O.R.E. Beliefs ~ Leave a comment

Good morning and thank you to everyone who liked and forwarded my post yesterday about the Crestline Culture Fair.  David is going to be very excited he is a star!

I am often asked, “Does my business need to have a financial statement?”  And, like all good professionals, my answer is, “Yes, but it depends.”

A small business can produce more than one type of financial statement.  Typically, the financial statement which people ask about is the Accountant prepared financial statement so this type of financial statement is what I am writing about today.  This is almost universally required when you have a large bank loan.    Your bank likes having a financial statement prepared by someone who understands the value of a well-designed financial report.  Which leads to the most important take-away for today.  Believe it or not…

Your financial statement is actually a marketing piece.

Think about this for a moment.  Your financial statement helps the reader – let’s say a banker in this instance – understand what your business does, how well you perform and the strength of your assets.  While your accounting system can easily produce “Profit and Loss” statements, “Balance Sheets” and even “Cash Flow” statements, these system financial statements are often hard to follow because accounts are not grouped and there is too much detail.  Do you want something that makes the banker smile or frown?

Far too often, the detail begs more questions than it provides answers.  Negative numbers where positive numbers are expected is the biggest issue that is faced.  Expenses that are wildly different from one year to the next, making comparison extremely difficult.  Accounts where the balance remains the same year after year, even though the balance should probably change given the nature of the business.  There are often valid reasons why account balances are different from year to year, but how do you go about explaining this to the bank?

Remember, the bank wants to help your business but your banker and the underwriter must feel that your business is creditworthy.  A well-prepared financial statement can help tell the reader a great deal about the business and how well it might manage the bank’s loan.

The reason your banker typically asks that you have a financial statement prepared by an independent accountant is that accounting professionals are trained in the art and science of financial statement preparation.  We make sure that the Company’s financial statements are easy to follow and understand.  This allows the banker to spend more time on knowing you and your business and less time trying to determine how your cash flows work.

If you are thinking about a bank loan, take a good, hard look at your financial statements.  Do the numbers make sense?  Is there too much detail that doesn’t tell the story?  Then ask your accounting professional to help you make sure your financial statements are ready for the bank.  We also have an Excel Spreadsheet for a very well-designed financial statement.  Feel free to contact me and I can email it to you for you to evaluate.  If you are not working with an accounting professional or would like to have a fresh opinion, feel free to contact us for a free evaluation.  At Currie & McLain, we are here to help you and your small business succeed.

 

Crestline Culture Fair

~ C.O.R.E. Beliefs ~ Leave a comment

Good morning.

A short post this fine day as I have a meeting coming up in a little bit.  I wanted to share about last night’s adventure at Crestline Elementary for David’s Third Grade Culture Fair.

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My fine young gentleman chose to honor his Mexican culture for the event.  When I interviewed him for this post, he was absolutely thrilled I was going to be blogging about him and his work.

He had to do all his own research about Mexico.  When asked how he started his research, he replied, “Grandma”.  Smart kid.

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He even hand-sketched the National Flag of Mexico.

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Kubae enjoyed the food court where she sampled Churros, Pan Dulce (this was David’s potluck dish), and Crimean candy.  We asked David how we came up with the idea for Pan Dulce and his reply, “Grandma.”  I know it is hard to tell in this picture but I caught him just beginning to laugh as he answered this question.  He still has to work on his poker face.

I am proud of David’s work and of course the hard work all the kids put into their culture boards and the foods provided by the families.  Congratulations to David and all the 3rd Graders of Crestline Elementary!

 

Cost of Goods Sold

~ C.O.R.E. Beliefs ~ Leave a comment

Happy Tuesday.  Today I am having lunch with Delena Meyer of Way Enough Decision Coaching.  I was fortunate enough to work with her at my last Company where we had to work through some growing pains. For an Organization facing pressures (aren’t we all) it is worth bringing in an outside consultant to bring a different viewpoint and work with the management team to find ways to move forward together.  I will have more to write about Way Enough Decision Coaching tomorrow but I strongly recommend her if you want a coach who can cut to the chase.  Her number is 360.281.4743.  Give her a call and let her know you were referred by John.

Cost of Goods Sold

Inventory is typically the largest dollar value of current assets in many small businesses.  This is especially true in retail, wholesale, construction and manufacturing.  When goods are sold, the dollar value of the items is adjusted from inventory to cost of goods sold (CoGS).  Which by the way, typically means that cost of goods sold is the largest “expense” item on the Income Statement.

I can hear my editor now, “John, if it is such an important number, why aren’t you tracking it on the Dashboard?”

The answer is, of course, that we are tracking it – using the amount in Accounts Payable as a reasonable substitute.  The goods in a business are almost universally purchased on terms so a healthy business will typically have inventory approximately equal to the amounts owed vendors.

I will spend more time on inventory in a later blog post, but the big take-away for today is that CoGS represents a significant item and it is the largest opportunity for error and irregularity in small business.

A Client Story on CoGS

About 2009, the firm had a client, ABC (named changed to protect the innocent) which was a specialty manufacturer.  The Company had borrowed a substantial amount of money from the Bank and had also bought out a major shareholder and owed on a term note.  The Bank required ABC to have a reviewed financial statement.  The information below is what the financial statements reported each year.

2005 2006 2007
Inventory
Raw Material       5,000,000    5,500,000    5,200,000
WiP       2,000,000    1,800,000    1,600,000
Finished Goods       1,000,000    1,300,000    1,000,000
Total Inventory       8,000,000    8,600,000    7,800,000
Revenues      18,000,000  19,500,000  20,500,000
CoGS      14,000,000  15,400,000  16,500,000
Gross Profit       4,000,000    4,100,000    4,000,000
Profit Margin 22.2% 21.0% 19.5%
Net Profit      (2,500,000)   (2,750,000)   (1,500,000)

The 2008 Surprise Change to Cost of Goods

The client sent over their internal financial statements and trial balance in February 2009 showing the following information:

2007 2008
Inventory
Raw Material    5,200,000    6,000,000
WiP    1,600,000    1,750,000
Finished Goods    1,000,000    1,250,000
Total Inventory    7,800,000    9,000,000
Revenues  20,500,000  21,000,000
CoGS  16,500,000  14,500,000
Gross Profit    4,000,000    6,500,000
Profit Margin 19.5% 31.0%
Net Profit   (1,500,000)    1,250,000

The first thing the staff noticed was that CoGS dropped by $2,000,000.  When you look a little deeper, you realize that inventory increased by $1,200,000.  For the professional, this looks a little suspicious so we started digging.  By asking the following questions (and others) we discovered the truth.

  • How can sales remain flat while CoGS drops by 12%?  Is there a new customer willing to pay a hefty premium?
  • Did ABC stop what it was doing at the end of the year and physically count the inventory?  Who reviewed the count sheets?
  • What are 2009 sales projections for ABC?  Given that we are in a tight credit situation, will sales grow in excess of 20% over 2008 to justify the investment in inventory?

The answers we received sadly required the firm to withdraw from the engagement.  But the point of the story is that as a small business, you should ensure your management team is on top of things like Cost of Goods Sold.  The balance is potentially large, there are huge dollar amounts flowing through the account and a small change in the margins can impact your profitability – and potentially your banking relationship.

My recommendations for staying on top of your CoGS:

  1. Require a full physical inventory count at year-end.  No matter how good your accounting system, a physical count helps keep the computerized data synced.
  2. Review your gross profit margin monthly.  If you are averaging 40% gross profit and it suddenly dips to 30% for no reason, ask questions.  It may be legitimate, it could be a posting error, or it could be something like fraud.
  3. Go out and spot count a few high dollar inventory items and compare your count to the accounting system.  You doing it yourself will show your team how important you think inventory and CoGS is to your business.
  4. Don’t try to hide a business problem by adjusting your CoGS.  In the story, the business had to show a reasonable profit margin in 2008 or the bank was going to place ABC in Special Assets.  ABC still ended up in Special Assets. Also, the CFO was terminated, shareholder/manager compensation was reduced by 80% and the business could no longer pay the notes to the retired shareholders.  4 years later the Company was liquidated for about $0.15 cents on the dollar.  A few years later I ran into the banker and he said that the Bank may have been willing to work things out with ABC had they not tried to fool them. Sad.

If your business sells goods, your CoGS plays an important part of your profitability.  It is intimately tied to your inventory levels and can be challenging to stay on top of.  Knowing how CoGS is related to your revenues and feeds out of your inventory can help you grow profitably and with fewer headaches.  Talk with your accounting professional if you have questions or feel free to send me an email if you would like to discuss this article or anything else regarding your business.

Have a great day.