If your small business is in the growth phase, that means you have survived your startup phase and are on your way, so well done!
The growth phase of a business is characterised by a rapid increase in sales. Customers have become aware of your business and know how your product or service meets their needs. So, they buy more and more, and more of them come to you, at least to try you out further.
However, I have to rain on your parade slightly to tell you that the growth phase of a business can be stressful times.
This is because the characteristics of the growth phase poses a number of challenges.
The rapid increase in sales puts pressure on your resources. While you may welcome the significant increase in customers and enquiries, it also means that the phones are ringing with orders, orders are being prepared, there are more and more customer conversations to be had and more to follow-up. This can cause a strain on your people and systems and the danger is poor communication or just not enough people so that you start to disappoint customers.
As well, your cash resources come under pressure. The rapid expansion means that your costs go up initially, while you try to increase stock levels and hire more people to cope. Your overheads and running costs increase to manage the extra activity. At the same time, cash is tied up in stock and accounts receivables while suppliers don’t provide enough credit because you don’t have a track record. You may have had to borrow from the bank to finance the expansion. All this leads to a cash flow situation where the money is needed to be paid out for wages and overheads, and to buy stock, often before customers pay their bills.
Another point of pressure may come if competitors also recognise your presence and start to compete more aggressively, by discounting their products or advertising more heavily. This means you need to start dealing with this competition while trying to maintain margins and profits.
There are things you can do.
You can certainly focus on your branding and marketing to compete. You can do things like seeking better terms for your long-term financing needs or ensure your hiring policies meet anticipated demand, and so on. However you need to be aware of the effects of all the growth phase symptoms in your business so that you can manage this phase well, and there’s no better guide than using some key financial measures.
I have 7 key financial measures that I believe will help you manage better.
I have said before and I’ll say it again – while you may hire accountants to calculate and report on your financial performance, you cannot abrogate your financial responsibility in your business. You are the business owner, and while you can delegate tasks, you cannot delegate ultimate financial responsibility. You need to understand what your finances mean.
So, what are the 7 key financial measures that will help you manage your business better?
They are measurements of strategic points in your business, especially in regard to the dangers in the growth phase. You can calculate all of these from your regular financial reports comprising of your Profit and Loss Account and your Balance Sheet.
1. Your Gross Profit Ratio
Your Gross Profit Ratio is simply your profit after the direct cost of sales (your Gross Profit) divided by your sales. This tells you how much you have left per sale to meet your overheads.
For example, if in a given month your sales is $20,000 and your direct costs (for example purchases of goods for resale adjusted for stock in hand) is $15,000, then your Gross profit is $5,000. That is what is left to pay for overheads like rent and wages that month.
Your Gross Profit ratio is 5,000/20,000 or 0.25 or 25% expressed as a percentage.
Stay with me!
If you’re not good at maths then get your accountant to work this out and explain it to you but get to know it!
You have to know it because you now know that your Gross Profit is 25% of your Sales, or, in other words, for every dollar of sale you keep 25 cents to pay overheads.
This helps you measure if you are making enough in each sale, and, how much in sales you have to make in order to cover all your expenses or break-even. The Gross Profit Ratio also measure how you are performing if you decide to cut prices in relation to competition and therefore how much you can afford to cut by to still break even.
You can also monitor this from month to month to see if you should, in fact, be increasing your prices!
2. Your Net Profit Ratio
Similar to the above but measuring your Net Profit (profit after all costs and expenses have been deducted). This is literally the profit you are left with.
So, in the above example, let’s say in the month being reviewed the overhead expenses (wages, rents, electricity etc) come to $4,000, then your Net Profit is $1,000. The Net Profit Ratio is therefore 1,000/20,000 or 5% of sales. If the overheads that month is roughly the same as for every month. then you can say that out of every $1 of sales you get to keep 5 cents.
You can measure this against your profit objectives and work out what your minimum sales must be in a month to meet your profit objectives.
You can certainly monitor this from month to month to make decisions about cutting overhead costs (not to the point of inefficiency – see number 7 below) or when to increase staffing and so on.
Both the Gross Profit and the Net Profit Ratios tell you how profitable you are during the growth phase – in other words, compared to your goals and objectives, is it all worth it and if not, how to improve it.
3. Current Ratio
Stay with me, these are just names that you can learn!
The Current Ratio tells you how much in reasonably convertible-to-cash assets you have as against what you owe people. It is called the “Current” Ratio because of an accounting premise that if you have any asset that is or can be converted to cash within 12 months, these are Current Assets. So, bank balances, inventory or stock, and accounts receivable, these are all Current Assets because they are cash or convertible to cash within 12 months. Your equipment, any vehicles owned by the business, and so on are not Current Assets because they are not desirably or feasibly convertible to cash within 12 months.
The other side of the coin are Current Liabilities – these are debts that you have to pay within 12 months, so they include accounts payable, 12 months’ worth of loan or lease payments, and so on.
You may have guessed that your Current Ratio is, therefore, Current Assets/Current Liabilities.
Let’s say that at the end of last month your Current Assets were $100,000 and your Current Liabilities were $80,000. Your Current Ratio is 100,000/80,000 or $1.25 to $1.00. This is interpreted as “for every $1 of Current Liability, you have $1.25 in Current Assets to pay it off when due. How strong your Current Ratio is can depend on your industry, where some industries traditionally operate with a very skinny Current Ratio, using the last sale to fund the costs of the next sale. An average “good” Current Ratio should be in the range of $2 for every $1 Current Liability. However, if your Current Ratio is any less than $1 to $1, you are likely to be facing a severe cash crisis.
Monitor this month by month. If it gets any worse than a previous period then get to the bottom of it! It may be because of an unusual circumstance (for example if you used some cash saved up to buy a Non-Current Asset but one that will generate more efficiency or sales). However, if you can see that it is caused by reduced sales (leading to fewer accounts receivable or cash), or increased costs (leading to more accounts payable) or something similar, you need to jump on it immediately.
4. Quick Ratio
While your Current Ratio is an early indicator of a cash squeeze, it does not tell you how soon the cash crisis is imminent. That’s because it assumes all Current Assets are convertible to cash within 12 months, not as and when needed to pay your bills. What you need is a measure that tells you how much cash you have to cover your liabilities.
This is called the Quick Ratio and is calculated by taking only cash balances and dividing by all Current Liabilities.
In the above example, let’s say that of the $100,000 in Current Assets, it is made up of $10,000 in cash, $40,000 in stock and $50,000 in accounts receivable.
The Quick Ratio is therefore 10,000/80,000 or 12.5 cents for every dollar of Current Liability.
If the Current Liabilities are mainly 30-day suppliers’ accounts, then you can see that in this example with only 12.5 cents in cash for every $1 of Current Liability, you need to collect the accounts receivables and convert the stock to cash before those supplier invoices are due (see below).
A “safe” Quick Ratio is $1 to $1 so that you know that you have the cash ready to pay any Current Liabilities.
Knowing this ratio, and its trend in your business keeps an eye on your liquidity.
It is an important fact to note that a profitable business can have poor liquidity because despite the increase in sales if the cash from these sales is converted to slow-paying accounts receivable or slow-moving stock, all your profits are on shelves or in your ledger rather than in the bank. Profitable businesses can be driven out of business because they do not have enough cash to pay suppliers and ongoing overheads month by month.
5. Accounts Receivables Turnover
So we turn to the Accounts Receivable Turnover to see whether your accounts receivables are collected in good time.
The Accounts Receivables Turnover tells you how many times your business turns accounts receivables into cash in a given period. Obviously, if your business is a cash retail business, this should be “immediately” in which case you should look at the next financial measure.
However, if you allow any credit terms at all, this ratio is critical to monitor cash flow.
The Accounts Receivables Turnover is calculated by taking total credit sales in a period and dividing it by the average balance of accounts receivable in that period. Only credit sales are taken into account because cash sales are converted to cash immediately.
For example, let’s say we are measuring the Accounts Receivable Turnover for the last month. The credit sales for the month was $20,000 (out of $30,000 total sales) and the average balance of accounts receivable in that month was $10,000. The Accounts Receivable Turnover is 20,000/10,000 or 2. This means that your accounts receivables turn over twice in a month, or to put it another way, it takes you about 2 weeks to collect credit sales.
Since this financial measure measures the efficiency of your accounts receivable, then the higher the ratio the better. If your ratio was less than 1 in a month, that is likely to mean that you are not converting credit sales to cash fast enough to pay all your 30-day supplier invoices. If you find that your Accounts Receivable Ratio is going up and down from month to month, try to identify why this is happening. Is it because there are specific customers who are late in paying you? You may need to tighten up on your credit control and remember – a non-paying customer is not worth the sale because a sale is only good if you convert it to cash.
6. Stock Turnover Ratio
Accounts Receivable is only one asset that may be tying up your cash. The other culprit is stock or inventory. The stock ends up on your shelf after you have paid for it. It represents a cash investment into the stock item. Therefore, if stock is left on the shelf for too long, that’s as good as tying up cash and leaving it unused on the shelf.
The calculation of Stock Turnover Ratio is similar to the above – sales in a given period divided by the average stock value during that period.
So, if sales are $20,000 for a month and in that month the average stock value was $5,000 your Stock Turnover Ratio is 20,000/5,000 or 4 times in that month. Again as it measures efficiency, the higher the ratio the better.
In all but cash retail industries, you need to measure both the Accounts Receivable Ratio and the Stock Turnover Ratio to find out the truth.
For example, even if your Stock Turnover Ratio was 4 in the month (selling your average stock balance 4 times a month sounds good) but your Accounts Receivable Ratio was 0.5 (your accounts receivable turn over only half a turn in the month, or it takes 2 months to collect cash from your average accounts receivable balance) then you will still be in a cash flow cirsis.
7. Wages Ratio
This is another efficiency ratio and measures how efficient your staff, or your systems operated by your staff, are.
It is calculated by dividing sales in a given period by the wages expenses of that period. For example, if your sales for a given month was $20,000 and your wages expenses that month was $5,000, then the Wages Ratio is 20,000/5,000 or 4 to 1. This means that for every $1 of wages paid, your business produces $4 in sales.
The higher the ratio, the higher the efficiency.
The Wages Ratio does not necessarily only show the efficiency of your staff but shows the efficiency of all the processes operated by your staff. If you find the Wages Ratio deteriorating, it may be because your staff are losing time on non-work activities, but it could also mean that the processes they use in their work activities are slowing them down.
As I said at the beginning, the growth phase in any business is cause for celebration. But you do need to be aware of the potential risks if you are not managing that growth properly.
You can only manage the risks if you are prepared to monitor financial measurements of your business, and then manage what those measures are telling you.
Small business owners often rely on their skills and experience in their industry to push through to success, but operating a business requires some all-round skills that go beyond industry or product knowledge. After all, you are in business to achieve your dream and provide a successful life for you and your loved ones, and this can only be done from the financial results of your business.
However, of course, I understand if you wish to delegate the preparation of your accounting reports and their interpretation to an accountant. Small business owners are busy people and this is no different to delegating the telephone answering to someone else. In fact, it is exactly the same – you still need to find the right person to answer the telephone, you need to tell them what you want in their job including what information to pass on to you, and you need to check on them every now and then.
You should not “just leave it” to your accountant, just as you would not “just leave it” to your receptionist. If you want to know how to find a good accountant or advisor, I have a free checklist on how to do just that.
Otherwise, you can make sure that you keep up with all the free tips, tools and resources that I send out to subscribers every week – go to teikoh.com and add yourself to the value list.