In a previous blog, we learned WHY benchmarking is so important. Here’s a brief refresh:
- It helps you understand your situation.
- It can be used continually. Benchmarking is not a use it once and pitch it solution.
- It provides you with real-time data. That is, as long your data is accurate, timely and relevant.
So now that we’re all up to speed, let’s revisit benchmarking again. After securing the accurate, timely and relevant data source you’ll use, the challenge becomes choosing which benchmarks to analyze and use as a proxy for business success.
Different industries, even different companies within an industry, could have different measures of success. For example, a contractor may have large subcontractor expenditures. Are these expenses normal considering the contractor’s sales volume?
Rather than define all these industry-specific key performance indicators (KPIs), we’re going to focus on a few financial metrics that are the most universally important to business and, when analyzed together, provide a quick and high-level review of a company’s health. Get excited.
- Net Profit Margin. Generally expressed as a net-profit before taxes in a given financial period divided by sales. Another way to look at it is how many cents of profit you extract from each dollar it earns in revenue. This may be a rudimentary financial metric, but it is also the most important!
- Liquidity Ratios. Did you note the plural usage? Good because there are two that need to be analyzed jointly.
- Current Ratio is expressed as current assets divided by current liabilities. This metric shows your general liquidity, however it has some limitations. By including inventory in the calculation, it may provide a distorted understanding of your very short cash flow.
- Quick Ratio is typically expressed as cash accounts receivable divided by current liabilities. Again, this ratio may not be perfect for gauging liquidity, but it is a useful and popular comparison to pair with the Current Ratio.
- Turnover Ratios. Plural again … because there are three this time to consider:
- Accounts Receivable (AR) is expressed as accounts receivable divided by sales, multiplied by 365 days. It roughly measures the number of days your company takes to turn accounts receivable into cash. Lower numbers are more desirable since it is better to have cash in the bank than extra receivable on the books.
- Accounts Payable (AP) is expressed as accounts payable divided by cost of goods sold, multiplied by 365 days. The accounts payable ratio indicates the number of days you take to pay its vendors. Here, higher numbers are better as it means you are able to hold onto cash longer.
- Inventory Days is expressed as inventory divided by cost of goods sold, multiplied by 365 days. Inventory days measures the number of days it takes to sell off inventory. As a note, this ratio is very specific to the industry. Imagine how long wine is stored at a winery compared to how long eggs are on grocery stores shelves. Generally, lower numbers are better.
By using some of these financial metrics repeatedly, you can being to build a picture of where your business should be going, where it’s excelling and where you can change and improve.