Do you understand what it’s saying?

Profitability is very important to business owners and they look to their CPA for guidance on how to improve it. Accurate financial statements are necessary, but that is just the beginning. CPA’s have a responsibility to guide business owners towards profitability. A good CPA does this by getting the financial statements to talk to you.  The best way to make that happen is to create benchmarks to compare against your actual results.

By far, the most important benchmark is an operating budget.  You must have a clear idea of the desired results so you know what you are working toward.  The budget should be challenging but attainable.  I recommend preparing a monthly budget for the entire calendar year.  You should compare the actual results to the budget every month and investigate any material variances.  Don’t be afraid to face the brutal facts about why the budget was not reached and whatever you do, don’t make excuses like “it was just a slow month” or “the budget was too hard to attain”.  As the owner, the first step toward a successful business is to be honest and hold yourself accountable.  It actually is a very powerful advantage in business.

My favorite exercise is to identify your company’s profit per “x” and monitor it religiously.  For example, a manufacturing plant may monitor its profit per direct labor hour or a hardware store may monitor its profit per customer visit.  Determine your profit per “x” by identifying the items in your business that have the greatest causal effect on your profitability and begin focusing on ways to increase it.

Another way to make the financial statements talk to you is to track several key performance indicators (KPI’s) in your business to measure if any trends are developing.  An example of a commonly used KPI is your current ratio.  This is measured by dividing your current assets by your current liabilities.  If the ratio is less than 1:1, you can expect cash to get tight.  Monitoring it monthly will help you see the trend of the ratio and it may prompt you to examine your borrowing needs ahead of time to smooth things out.

Collecting your money is vital to your survival.  Measuring the turnover of your accounts receivable helps you see how quickly you are collecting your money.  This is simply measured by dividing your annualized sales by your average accounts receivable.  This ratio will give you an indication of how quickly your customers are paying you.  If they are not paying you fast enough, you may be running the risk of incurring bad debts and need to tighten your credit policy.  If they are paying you too quickly, your credit policy may be too strict and you could be passing on good sales as a result of it.

Businesses that maintain inventory know the potential risks and the related costs of keeping too much inventory for too long.  Measuring how many days your inventory sits in the warehouse will help you understand how much you should keep on hand so you are not tying up valuable cash or room on your line of credit.  You may even have too much unnecessary warehouse space.  It could also give you an indication if you are holding significant amounts of obsolete inventory.

To go one step further, consider departmentalizing your financial data by product line and measure your margins against what you think they are.  You may learn that some less developed product lines are more profitable than you thought. The next step is to adopt a fully integrated marketing campaign to help drive up sales of that product line. Continue to measure the results and if done right, your profits should begin to trend upward.

Remember, that the more benchmarks you have, the more clearly it will help you to see the performance of your business and where you can improve it. I have always lived by the rule, “what you can measure you can manage, and what you can manage you can improve.” Many trade associations have industry data available that can be very useful in seeing how you measure up to your competition. Do not be afraid of what you might learn. Keeping your head out of the sand is the beginning of a long and exciting trend toward increased profitability.