I believe one of the most important roles of the small business executive is “Scorekeeper”. You make sure the score is being kept in your business and that your team members are seeing the numbers they need to see.
My experience is that many small business owners see monthly financial statements such as the Income Statement and the Balance Sheet and aren’t sure what to make of all the data. Hence, the reports get a quick look-over and then get filed in that big file folder in the cloud where they will never see the light of day again.
Using your most current financial statements, here are my top five financial numbers to track. How many are you currently tracking today?
#1. Sustainable Growth Rate.
I am often asked by clients, “How fast should I grow my company?” Tough question. There are lots of risks involved in growing too slowly or too fast. The Sustainable Growth Rate calculation helps us determine a “safe” rate of growth for our business given three sets of assumptions: net profit percentage, debt/equity mix, and the number of variable assets on our balance sheet.
This formula not only tells us what our Sustainable Growth Rate is currently, but it also allows us to do “what if” analysis to see how we might either speed up our rate of growth or possibly slow down.
There are more than a dozen key financial ratios a business owner can use to determine the financial health of the enterprise. What if you could combine several and look at a weighted average? This is your Z-Score.
The Z-Score was first calculated by NYU professor Dr. Edward Altman while attempting to determine if it was possible to predict if a company was heading for bankruptcy. He found four ratios that were all highly predictive of financial decline, assigned relative weights to each ratio, and then added them together to reach his Z-Score. This calculation is essentially your business credit score. The formula can also create a variety of “what ifs” to see how you might raise your score. Raise prices? Reduce debt? Improve liquidity?
#3. Working Capital Requirements
Do you have enough cash (liquidity) to grow your business? Way too many small businesses run out of cash chasing aggressive growth strategies. Is it possible to calculate the right amount of accessible working capital to avoid this financial malady?
The answer is yes. It’s called Working Capital Requirements. It takes into consideration how fast you are turning your inventory, and accounts receivables, besides how fast you are paying your vendors. For example, let’s assume you calculate your number and it is $50K. This would suggest that your business needs to have access to approximately fifty thousand dollars in order to avoid running out of cash. This $50K would include your corporate checking balances, your line of credit, credit cards, and any liquid assets you may have.
The biggest challenge is that for a growing business, this number is also growing. A good banker is aware of this challenge and will offer your business more capital than you might need today to facilitate your cash needs in the future.
#4. Revenue Per Employee
This is a great measurement of employee productivity. The average small business generates approximately $100K in revenue per employee per year. Larger companies, the Fortune 500, average about $300K in revenue per employee. The oil companies, generally very profitable, average about $2 million in revenue per employee each year.
What about your company? Calculate your number by taking the last 12 months’ revenue divided by the average number of full-time employees (FTEs) for that same time period.
This number is also very helpful in making hiring decisions. Successful companies establish a benchmark for their number and only add employees when their Revenue Per Employee exceeds that benchmark.
#5. Return on Investment (ROI)
As the owner of the business, it is likely that you are also the primary investor. It’s important for the lead investor to be confident that the business is generating a sufficient return on your capital investment. This is an easy calculation. Take your annual net profit as reported on your Income Statement and divide it by the amount of owner’s equity reported on your Balance Sheet.
How much is sufficient? As an investor, you certainly have other options for investing your hard-earned money, such as the stock market, a real estate investment, or even a much-deserved vacation. A savvy investor will compare the return they’re getting from their business as opposed to other such options.
An INC Magazine article several years ago suggested that a small business should generate 20-25% ROI. Why so high? This is a relatively risky investment. 75-80% of small businesses fail in the first three – five years. It may be hard to imagine your business failing, but the facts speak for themselves. Your business should pay you (the investor) a premium in its ROI to compensate for such a risk.
For help calculating these rations, visit the “Tools” section of my website to access each one.
I also recommend a great book for better understanding small business financials: Financial Intelligence written by Karen Berman and Joe Knight.
Good luck keeping your business score!