As a business consultant, I’m often asked, “what are the most important financial metrics that, as a business owner or decision-maker in a business, you can pay attention to?”
There are several key financial measures that provide insight to the financial health of your business. I believe reviewing any financial measures is helpful. However, there are three that truly give you a good indication of current performance.
#1: Gross Revenues
Gross revenues measure the total amount of dollars recognized during a financial period from providing services or selling goods. It is important to note that revenues are only recognized when they are earned. A business can’t include any revenues recognized from a good or service that have not yet been earned.
For example, ABC Manufacturing sells 10 wingdings for $150 each. While there are 15 wingdings available for purchase, only 10 were actually sold during the period. Revenues for this financial period are (10 wingdings x $150) $1500.
#2: Gross Profit
Referencing the example above, each wingding requires materials and labor to produce. For ABC Manufacturing, each wingding costs them a total of $105. These costs are typically referred to as Cost of Goods Sold. In this example, Cost of Goods Sold is comprised of $75 worth of materials and $30 of labor to put the wingding together.
Why is this important? Remember that each wingding sells at $150. With a total cost per wingding of $105 that allows for a gross profit of $45 (Gross Revenues less Cost of Goods Sold). Put simply, for each $1 of wingdings sold, ABC Manufacturing realizes a Gross Profit of $.30 ($150 less $105 = $45, $45/$150 = 30%).
Keep in mind that ABC Manufacturing incurs expenses for running the business in addition to the direct costs associated with producing wingdings. Expenses such as rent, utilities, office supplies, administrative labor, advertising, and insurance are all examples of Selling, General and Administrative Expenses. There must be enough Gross Profit remaining to cover all Selling, General and Administrative Expenses.
In this example, Gross Profit for each wingding is $45. In this period, ABC Manufacturing sold 10 wingdings, which realized sales of $1500, with associated Gross Profit of $450. Therefore, Selling, General and Administrative Expenses must be less than $450 for ABC Manufacturing to realize a positive Net Income for this period. Business owners need to know Gross Profit, so they know the primary efforts of their business will result in a positive financial outcome.
#3: Cash Balance
Cash is critical. Without cash, a business owner is unable to pay invoices. Without cash, a business owner is unable to pay employees. In summary, without cash, a business cannot survive.
To increase cash balance, a business owner can increase sales. Increasing sales alone is not necessarily the answer though. If 100% of sales are on credit, then cash does not change, but accounts receivables increase. To combat this, invoice faster and reduce the payment terms. In other words, make it financially attractive for customers to pay you in cash and to pay off their outstanding balance.
Decreasing expenses is another obvious solution. Spend less, keep more. Evaluate your expenses and determine those that are business critical (cannot provide business without the expense), business necessary (at some point will be needed to sustain business operations), and business optional (a luxury items that can be eliminated).
Thirdly, how much cash do you really need? Prior to 2020, we would typically advise clients to maintain three months cash to cover expenses. However, that changed with the pandemic. Post-pandemic we suggest six to nine months.
Finally, remember that profitability does not equal cash. A business can be profitable, but with a terrible cash balance.