Critical Business Financials Explained

Critical Business Financials Explained provides a commentary on Tips that appear in the 12Faces Dashboard spreadsheet.  

You can access information in 3 ways:

  • Blue coloured links in the spreadsheets connect to their specific topic for a quick study.
  • Read the full article to get a more general understanding on the range of items covered.
  • Click on any of the links in the Table of Contents below to go straight to that topic.

If you find the information generated by a particular Topic useful, and feel inspired to go further to optimise or grow your business,  
12Faces has Campaigns that will step you through the process:

  • Turnaround30 - designed to help you stabilise a troubled business in as little as 30 days.
  • Optimise100 aims, over 100 days, to optimise the income and expenses in your business so that you create a stable, healthy business.
  • Grow365 goes the next step.  You want to grow your optimised business systematically to avoid the many pitfalls of unorganised growth.

To self-diagnose your business financials problems:
Go to the introduction: DIY Business Problems Diagnostics
Registration is required, but it is FREE.

When faced with a lot of information, it can be difficult to work out where to start.  Corrective action is all too easily deferred.
Prioritising Alternatives can help to overcome this decision making roadblock. 
Go to the article: Using Weights and Scores Prioritising Technique

All information generated by the 12Faces spreadsheets, and the information provided below, is indicative only.  We don't know the particular circumstances of your business.  Consider our information as suggestions only.  For specific advice on any of the issues raised in the spreadsheet, consult an appropriate professional.

Table of Contents:

#1 Change in Price
#2 Change in Cost of Goods Sold
#3 Reduce Overhead Costs
#4 EBITDA
#5 Accounts Receivable and Payable
#6 Profit Funnel Group
#7 Inventory Measures
Inventory Turns
#8 Return on Equity
#9 Gross Margin Percentage
#10 Labour Cost and Efficiency Measure
#15 Liquidity Ratio
#12 Working Capital
#13 Interest Cover
#14 Breakeven SalesSafety Margins
#16 Safety Margins

#1 Change in Price

A change in price is often one of the most impactful changes you can make in your business.
A study of some businesses several years ago indicated that a 1% change in Price led to an average of an 11% change in Net Profit.

For the impact of Price on your Revenue, and therefore your Profit, see the following links:

#2 Change in Cost of Goods Sold

The “Cost of Goods Sold” (COGS) refers to the cost of the inputs that go into producing the product that you sell. 
Often referred to as "Variable Costs".

If the expense disappears when you stop producing the product or service, then the expense belongs here.

  • Do not include your permanent workforce in this.  They are essentially a Fixed, or Overhead, Cost. 
  • Include any specialist contract or casual labour that would not stay in your business if you stopped producing this product.

Reducing the Cost of Goods Sold has a direct and immediate impact on your Profitability.  That impact will continue as your Sales Volume increases or decreases. 
The COGS is directly tied to your sales.

For more on COGS visit the following links:

#3 Reduce Overhead Costs

“Overhead Costs” are costs that don't fluctuate in line with changes in your Sales Volume.
They include such things as insurance, rent, permanent labour, telephone and other office costs.

Reduce these costs and watch the savings flow immediately to the Profit line.  Often, these costs are comparatively difficult to reduce because they come in “lumps”. 
For example, rent is unlikely to be reduced without substantial changes to the locations you rent.

Further information on reducing Overhead Costs at the following links:

Above are a number of links covering Overhead Costs. This is a large topic, the above will link to further articles on such an important topic for the success of your business.

#4 EBITDA

The EBITDA (Earnings Before Interest Tax Dividends and Amortisation) starts with the Operating Profit you submitted. It then adjusts to a Profit figure that better reflects where you want to be.

To do this the EBITDA figure:

  • Adds back Deprecation if it has been charged.
    Although this is a future cost you need to know, it can be distorted by, for example instant tax write-offs, to show greater cash cost than really occurred.
  • Adds back Interest Paid.
    The money to run your business can be drawn from many sources with different interest rates. Adding this back removes any bias.
  • Deducts any underpaid Salary to the owners. 
    Profit is being over-represented compared to a Profit with a realistic Owners salary deducted.
  • Deducts any Expenses being paid as a subsidy by the Owners.
    These are, ideally, costs paid by the business if it was able.

Further information on EBITDA go to the following link:

#5 Accounts Receivable and Payable

“Accounts Receivable” refers to money owed to you by your customers.

“Accounts Payable” refers to the money you are paying your Suppliers.

The speed at which you receive money owed to you from sales and pay money that you owe your suppliers doesn't impact your Profit & Loss directly. 

They do have an impact on your Cashflow.  The slower you collect your debts, and/or the faster you pay your payables, the worse your cash availability will become.

Accounts Receivable:
Using the data you supplied, you can estimate how many days, on average, it is taking you to collect your Accounts Receivable.

This appears under the Performance Measures titled, "Days A/R Outstanding".
This is the average number of days it is taking you to collect your Accounts Receivable.

To see the impact of 1 day change adjust:

  • The “Days less A/c Receivable” value in the Change part of the spreadsheet.
  • Change it from the starting point of 1 day to as many days you think you can reduce it by.

Accounts Payable:
The estimated days it takes you to pay your suppliers is listed under the Performance Measure titled, "Days A/P Outstanding".

Again, you can see the impact of a 1 day improvement in Accounts Payable by adjusting the change:

  • As you increase the change from 1 day, you are taking more days to pay your suppliers.
  • Meaning that any difference between the speed at which you are recovering your money from your buyers and paying your suppliers is improving.

In the Performance Measures section:

If your Accounts Receivable takes longer to receive than the speed at which you are paying your suppliers, it will be shown in red.

This indicates that:

  • You are using valuable Working Capital to pay suppliers rather than paying them with money received from your buyers.
  • Working Capital is important.
    • If it is low, it may have to be boosted by debt which incurs the cost of interest.
    • Other times, Working Capital can be used to fund growth but not if it is in short supply.

For more on managing Accounts Receivable and Accounts Payable, visit the following links:

#6 Profit Funnel Group

The Profit Funnel Group measures the changes in the different levels of the items that make up your Profit Funnel.

  • Trading Revenue (Sales Income) is tipped in at the top of the funnel.
  • It passes through Cost of Goods Sold (COGS).
  • Then Overhead (Operating) Cost stages.
  • Eventually leaving a Profit.

The final Profit will vary with the efficiency of each of the levels in the Profit Funnel.

For more on managing Accounts Receivable and Accounts Payable, visit the following links:

#7 Inventory Measures

Inventory represents:

  • Raw materials that you have received from your supplier.
  • Finished product that you are holding prior to selling to your buyers.
  • All Work in Progress (WIP) that is partly completed product.

Inventory has an important effect on Cashflow but doesn't directly impact Profit.  Inventory appears in the Cashflow part of the spreadsheets.

The more money tied up in Inventory in your business, the less ready cash you will have available.  You will have to consume your Working Capital to cover costs.  Very often, Inventory is treated as an Asset in accounting books, but this is an "academic" notion.  It doesn't take into account that it is slowing down the flow of cash into your bank accounts.

“Days less Inventory”
Shows how much cashflow is generated for each day less that you hold your inventory.

“Inventory Turns”
Refers to how many times in a year you sell the equivalent of your entire Inventory.  This will be influenced by the industry that you are in.  There is no single figure that can be taken as "good".
A web search might find a benchmark for your industry.

It is very clear that the more "turns" you have, the more product you have sold and therefore the greater your Revenue. Higher is better.

The other side of that coin is that, the faster you can turn over your Inventory, the less Inventory you will be holding at any point in time.  Your cashflow will benefit from increased "Inventory Turns".

“Days Sales of Inventory”
Measures how many days it takes for Inventory to turn into Sales.  There is no hard rule for what this figure should be.  But the smaller it is, the faster your Inventory is being turned into cash.  Your goal will be to reduce this figure.

The “Inventory Turns” and the “Days Sales of Inventory” are closely related.  As you speed up one of them, the other will improve as well.

For more on Inventory, use the following links:

#8 Return on Equity

The “Return on Equity (ROE)” measures how much Profit you are making for each dollar of Equity in the business.
Also known as Return on Investment (ROI).

You are comparing the return you are getting for operating your business to what you would get by investing the same amount of money in a bank account or the stock market.

You are taking more risk with your own business than money in an interest earning bank account.  You will want a better return from your business than you get on the largely risk free bank deposit to compensate.

If your ROE is close to or lower than what you might get in these alternative investments:

  • Give some thought to either improving the Return
    or
  • Selling the business.

Some experts say, as a rule of thumb, that a 5% ROE is essentially no return at all.  This is after allowing for some margin for the extra risk of running a business.

The higher this number, the better your business.  In the spreadsheets, this will appear red if below 5% and yellow if below 10%.

For more information on ROE consult the following articles:

#9 Gross Margin Percentage

“Gross Margin Percentage”
Gross Profit divided by Revenue = Gross Margin Percentage

"Gross Profit"
Revenue minus Cost of Goods Sold (COGS) = Gross Profit

There is no single acceptable figure for this "Gross Margin Percentage".

It will:

  • Vary widely, depending on the nature of your business.
  • Be a comparatively low figure in a competitive retail environment.

Example:

  • A grocery shop's retail selling prices are not much greater than the cost of the products they sell.
  • In an industry where you have few competitors you are able to charge more for your products.  We would expect the "Gross Margin" to be much higher.
  • The "Gross Margin" would be higher where most of the cost is staff. Staff is an Operating Cost, for example, a consultancy or accounting practice.

There is quite a lot of information to be gained from the study of "Gross Margin Percentage" when you look at it over time.

Your Revenue will change and independently of that, your COGS will change.
Because both of these change, your Gross Profit will also change; but you may not be able to tell why.
Remember: Gross Profit = Revenue - COGS.

The Gross Margin Percentage will, consequently, go up and down.
Remember: Gross Margin Percentage = Gross Profit / Revenue.

The fluctuation in your Revenue and COGS is very confusing when you are trying to see if you are better or worse off over time.
The Gross Margin Percentage is a useful tool for trying to see the aggregate impact of changes in your Revenue and COGS.  These are otherwise quite difficult to work out.

Your goal is to keep your Gross Margin Percentage at least steady.
This means your Revenue and COGS are moving in the same direction at similar rates.

Even better, if it is growing it reflects increasing efficiency and economies in your business.

If it falls, your Revenue and COGS are moving apart and need correction.

For more on the usefulness of the Gross Margin Percentage study the following articles:

#10 Labour Cost and Efficiency Measures

Some Labour costs vary according to the volume of your production.  This will mostly be outsourced or casual labour and belongs in COGS.

Most of your Labour is a Fixed Cost, since you don't rapidly turn over your permanent staff.  It is an Overhead Cost.

It follows that the most flexible Overhead Cost is likely to be Labour, if you have a workforce of any size.

Under the heading "Labour Reduction", you can see the impact of a percentage reduction in your cost of Labour.

As you may have Labour at many different wage points, a percentage may be difficult to estimate.  Instead, you may be able to calculate the savings from letting specific people or job descriptions go.

As an alternative, set the “Labour Reduction” to zero.
Then fill in the sand colour cell labelled “OR Estimated Wages Saved”.

Enter either:
A percentage change if you are playing around to see the results.
or
An actual estimated saved.

But not both.

For more on deciding which staff may be unnecessary, visit the links below:

Over time, Labour costs tend to blow out.  You hire more Labour but don't remove the less efficient, no longer required or less useful Labour.

This is especially true in growing businesses.  You tend to employ Labour in advance of having Sales Revenue to pay for it.  This consumes your valuable Working Capital.  It can stunt your businesses growth or damage your liquidity.

It is therefore useful to see how much you are investing in your Labour and how well it tracks your Income.

If the “Labour to Revenue Ratio” gets bigger over time, you are spending more on Labour for every dollar of sales.  This is a sign of Labour bloat and/or Labour inefficiencies.

Ideally, you want this number to get smaller.  This means your use of Labour is becoming more efficient.

For suggestions on how to manage Fixed Labour Costs visit the following links:

#15 Liquidity Ratio

It is possible to have a business that appears profitable but you never have enough money to pay your expenses.  The availability of funds to pay expenses when they fall due is your "Liquidity".

The number in the cell M12 (Liquidity) gives you an indication of how much padding you have to cover Expenses as and when they fall due.

Liquidity relies on the ratio between your Current Assets and your Current Liabilities.
It assumes that your Current Assets can be converted to cash relatively quickly to cover your Current Liabilities when necessary.

There is no hard and fast rule about what your Liquidity Ratio should be, but many experts think that any less than 1.5 is moving into dangerous territory.
This can be interpreted as:

  • You have $1.50 in Current Assets to cover $1 in Current Liabilities.

The smaller this ratio becomes, the more difficult it will be for you to cover your expenses.  This is especially true when you are not able to convert assets fast enough to cover pressing expenses.

A business with a Liquidity Ratio falling over time may be heading for bankruptcy or forced sale.  This is one of those numbers that the bank and other lenders are likely to be looking at.  They are very interested in your ability to cover debt payments.

The Liquidity Ratio is therefore important to monitor and important to try and improve.

For more on managing your Liquidity visit the following links:

  • I Don't Know What is Wrong
    Click on the link under Table of Contents:
    My Sales and Profit are OK but I keep running out of Money.
  • Skills Module introduction: SM6.0 Profit Autopilot - Introduction
    Here conventional accounting is turned on its head by starting with a focus on Profit first.
    Learn about "Piggy Banks" and never be worried about having sufficient funds to pay your debts, including tax.
  • Liquidity Ratio 12Faces search: Learn About Liquidity
    Refresh your screen to update the list.

#12 Working Capital

“Working Capital” is another measure of your available funds.
It is the amount of money you have at your disposal to spend on growing your business in the future.

  • The lower this figure is, the more funds you have available to fund your growth.
  • The higher the figure the more money, that could otherwise go to cash, is tied up in funding the day-to-day business operations.

Current Assets minus Current Liabilities = Working Capital

If you don't have a great deal of Working Capital, the only way you will be able to afford to grow your business is to borrow money.  Any business that intends to grow should focus on ways of building up its Working Capital reserves to "self fund" proposed growth.

"Working Capital to Sales Ratio" is another useful figure.

  • We want this figure to remain stable, or to grow, because it reflects how much cash has been generated by your sales.
  • A disproportionate growth in Working Capital compared to growth in Revenue (Sales) is generally not a good trend.

If it begins to fall it indicates that your Revenue is growing but your Cashflow is worsening. This is common in a growing business drawing down on cash reserves.
This statistic is best used when compared over several time periods to make sure that it doesn't deteriorate markedly.  It is an early indicator that you are growing Sales at the expense of Cashflow.

For more on the importance of Working Capital visit the following articles:

#13 Interest Cover

“Interest Cover” refers to how much money you have available to cover the cost of your Interest on your Loans and other similar debt.

There is no hard and fast rule for a “safe” Interest Cover but experts say it would be wise to have an Interest Cover figure in the order of 5.  In our spreadsheet, anything less than 5 will be highlighted in red.

Interest Cover is important, those who lend you money want to know that you have the ability to cover the Interest payments.

Ultimately, they want to know that you have the ability to repay the loan.  Very likely, they will be monitoring this figure. 

It is wise for you to track it yourself in order to see when it is moving unfavourably.  Make any necessary changes yourself rather than get a rude shock when you hear from a nervous banker.

For more on Interest Cover read the following:

#14 Breakeven Sales

This figure is provided more for information than for management purposes.

It represents the amount of Sales you must make to cover both the cost of production (COGS) of those products you sell and your Fixed Overhead Costs.

If your Sales start to move downwards towards Breakeven: 

  • It is an indicator that your business is becoming distressed. 
  • Consider reducing your Overhead Costs.

If Sales fall below the Breakeven figure: 

  • Your business is financially distressed and you are living off your savings.

If your Sales have fallen below the Breakeven figure, the following will be of assistance:

#16 Safety Margins

The two Safety Margins indicate how long you can trade if something adverse happens to your revenue and you don't make any compensating changes to your operation.  This might happen with some sort of emergency like fire, flood or Covid.  In both cases, the larger the number, the more safety you have. 

It is a management decision as to how much safety you feel is appropriate.  There is no particular recommendation.  You might set more or less safety depending how much of these types of risk your business faces.

You should watch the the Margin does not fall below what you consider to be a reasonable level.

Days Safety Margin: is how many days you could operate and cover your costs with no more income in the period and assuming you don't take steps to reduce your expenses when the problem hits

Margin of Safety: is how far your revenue could fall before you are no longer covering your costs.  The concept is especially useful when a significant proportion of sales are at risk of decline or elimination.  This might be the case when a sales contract is coming to an end or a major customer stops using you.  By knowing the amount of the margin of safety, management can gain a better understanding of the risk of loss to which a business is subjected by changes in sales.  If you have a margin of 20% and you are about to lose a customer who is 40% of your trade, you are in trouble. The opposite situation may also arise, where the margin is so large that a business is well-protected from sales variations. The margin of safety concept does not work well when sales are strongly seasonal, since some months will yield catastrophically low results. In such cases, annualize the information in order to integrate all seasonal fluctuations into the outcome.

  • Breakeven 12Faces search: Safety Margin
    Refresh your screen to update the list.

Disclaimer

All information generated by the 12Faces ScoreBoards and the discussion above is indicative only.  We don't know the particular circumstances of your business.  All our recommendations must be considered as suggestions only.  For specific advice on any of the issues raised in the spreadsheet, consult an appropriate professional.

Resources

There are plenty of books on business ratio analysis, should you want to know more about any of the ratios listed here.

Google a particular term and you will find an explanation.

These ratios are widely used in business. 

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