Measuring and assessing your business performance is easier than you think.
1. Common Size Analysis
Common size analysis is a fancy term for looking at your income statement and balance sheet as percentages instead of numbers. This allows for better comparisons to other periods or industry benchmarks. Most bookkeeping software has this capability for you in the report tool, often denoted by a “%.”
- Income Statement: Common size analysis in the income statement measures all accounts as a percentage of total revenue. By comparison multiple periods in the common size format, you’ll notice changes in gross profit and key expense categories. Take note of large changes +/- 5% period over period, or compare your income statement to benchmarking data from IBISWorld or Vertical IQ. Consultants at your local Small Business Development Center “SBDC” can provide this data for you and help you with the benchmarking process.
- Balance Sheet: The balance sheet is measured as a percentage of Total Assets in the common size format. Analyzing the balance sheet using the common size approach is less common however it can be very impactful. For example, you can compare cash reserves, debt, accounts receivable, or inventory levels seasonally or with industry benchmarks. These insights will enable you to identify how much working capital may be required to grow your business..
2. Ratio Analysis
Ratios are used every day to gather insights using two data points. For example, miles per gallon uses two data points to measure fuel efficiency of a vehicle. Similarly, we can use data points from the income statement and balance sheet to measure efficiency and performance in a business.
Ratios can be broken down into categories: Profitability, Liquidity, Turnover, and Leverage. It is important to note that no single ratio provides all the insight you need to operate a business. A good analogy is flying a plane. The pilot uses a number of instruments to fly the aircraft and safely arrive at the destination. Along the way there may be some turbulence or weather systems that can be navigated so long as the pilot continues monitoring the instruments and communicating with air traffic control. Analyzing your business is very similar
Profitability Ratios:
- Gross Profit Margin
- Net Income Margin
- Return on Assets
- Return on Equity
Liquidity Ratios
- Current Ratio
- Quick Ratio
- Days Sales in Cash
Turnover Ratios
- A/R Turnover
- A/R Collection Period
- Inventory Turnover
- Inventory Days on Hand
- Fixed Asset Turnover
- Payables Period
Leverage Ratios
- Debt to Assets
- Debt to Equity
- Interest Coverage Ratio
- Debt to EBITDA
- Debt Service Coverage Ratio “DSCR”
Not every ratio is ideal or applicable for every business, and there are pros and cons to each. It is important to speak with your accountant or SBDC consultant to discuss which ratios are appropriate for your business. The important takeaway here is that these ratios can all be created with data that already exists within your income statement and balance sheet (with the exception of the DSCR).
3. Forecasting & Variance Analysis
Forecasting can be a daunting task but there are inexpensive software applications that can make the process very easy. A forecast enables you to plan for the future. Most importantly for growing businesses, a forecast provides a cash flow projection and illustrates when you may experience a cash crunch and need additional capital. The process requires you to make assumptions about sales and future expenses. Many business owners fail to take the time to look back and review the old assumptions, identify why the assumptions were incorrect, and make improvements. Analyzing your actual results vs expected results is called Variance Analysis.
In summary, basic financial analysis of your business is less daunting than you may think. The key is to set up a routine every month to review the key performance indicators “KPIs” of your business and continue to steer your business in the right path similar to the airline pilots using the instruments to steer the airplane. KPIs are a term to describe a selection of metrics (3-8 in total) that can be easily measured and monitored and provide an overall assessment of business performance. It is not expected nor reasonable for a business owner to measure every single metric available. However, managing a handful of data points across various areas of the the business on a regular basis will have a profound positive impact on overall performance.
