When most people want to know how they’re doing financially, they take a peek at their bank balances. Bank balance accounting—although wildly popular—is a lousy method for accurately assessing the health of a business. If that's your method, it's time for a change.
Metrics for Tracking Your Money
The following four calculations will help you better determine your moneymaking potential in a day, week or month—depending on your type of business.
1. Current ratio = current assets/current liabilities. While lots of folks get themselves needlessly worked up over five years’ worth of financial projections, an incredibly useful metric can be a company’s immediate ability to pay its bills. If you divide current assets by current liabilities, you get the current ratio—a measure of a company’s liquidity. If a business has little to no liquid value, that can be a red flag.
2. Profit margin = net income/sales. If you divide income after expenses by total sales, you get an idea of what percentage of every dollar a company keeps—basically, the profitability of a company. If you’re comparing several businesses, keep in mind that standard profit margins vary widely from industry to industry. A profit margin that’s far too low indicates inefficiency and is a warning sign that something needs to change.
3. AR turnover ratio = sales/average accounts receivable. Knowing whether or not a company handles its accounts receivable in an efficient manner is a huge part of assessing that company’s health. A high ratio demonstrates that a company extends credit carefully and collects receivables in a timely fashion. A low ratio indicates that a company is extended too far and needs to step up its collection practices.
4. Debt to equity ratio = total liabilities/total stockholder's equity. Dividing a company’s liabilities by the total of the stockholder’s equity gives you a read on how much debt the company is carrying compared to what the company is currently worth. It shows you if a company is overextended or undervalued.
Predicting the Future
The first four metrics come from traditional accounting practices, but there’s more to assessing your company’s health than looking at where you are at any given moment. What about the future and getting a general idea of where you're headed? Let’s look at the four calculations that will help predict future revenue.
5. Days to convert a lead to a client. This figure is based on the date of the first significant contact with a potential client and tracks how long it took your company to convert them to an actual client. Perform this calculation for all your new clients, and you’ll get an average, a calculation—expressed in days—that you’ll use to arrive at other figures.
6. Lead conversion rate = clients/prospects. Since no one converts every lead into a client, you need to know what your success rate actually is. Divide clients by prospects to get this ratio.
7. Weekly lead generation. How many leads per week do you have to work with? For B2C businesses—like a coffee shop—this figure may be calculated daily, based on the high volume of small dollar purchases. For B2B companies, you may be looking at a monthly, or even yearly figure.
8. Predicted revenue = conversion rate x weekly lead average. Once you have the metrics from numbers 5 to 7, you can calculate your anticipated revenue. Multiply your conversion rate by your average leads per week, and based on your days that it takes to convert a client, you can predict when your revenue will come in.
So what do these numbers actually tell you, other than that you’ve passed our little basic accounting class? If you’re looking at your own company, you’ll be searching for ways to assess what you’re doing well, and what you need to improve. If your debt is low, your sales are high and your predicted revenue looks great, but your AR turnover ratio is lousy, then you’ve learned that by improving your collections practices you can make your company healthier.
If you’re looking at a competitor that’s really giving you a run for your money, yet you know they’re leveraged up to their eyeballs owing way more than the company’s worth, then you need to abide by these accounting practices. It will help keep you strong and steady, and will win you that war. You’ll be in business for the long haul, while their unsustainable model falls apart.
Read more articles and see exclusive videos in OPEN Forum’s special section on Managing Your Money.
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