Business owners have dozens of reports available at the click of a button, but some basic metrics can help you make smarter business decisions. Here are six metrics every business owner should review each month.
#1 Contribution Margin
The contribution margin formula is (sales – variable costs), and this formula is a great tool for evaluating fixed costs.
Assume, for example, a product’s sale price is $100 per unit, your variable costs per unit total $60, and total fixed costs are $3,000. If you sell 100 units, sales total $10,000 and variable costs add up to $6,000. Your contribution margin is ($10,000 – $6,000), or $4,000.
The $4,000 contribution margin covers the $3,000 in fixed costs, and the remaining $1,000 balance is profit.
This metric helps you determine the number of units you must sell to cover total fixed costs and generate a desired level of profit. Note, however, that fixed costs should always be viewed in total dollars, not as a fixed cost per unit.
#2 Breakeven in Units
The breakeven in units formula reveals how much you must sell to cover your costs, and sales above the breakeven level generate a profit.
Here is the breakeven in units formula, assuming that “X” is the number of units sold:
$100X sales – $60X variable costs – $3,000 fixed costs = $0 profit
To solve for X:
$40X = $3,000
X = 75 (units)
The firm must sell 75 units to breakeven
Any component of the formula can be easily changed to consider the impact of a different sale price, a change in variable costs, or an adjustment in total fixed costs.
#3 Profit Margin
It’s a simple formula, but every business owner should compare the profitability of products using profit margin, which is defined as (net income) / (sales). Profit margin tells you the profit you make on each dollar sold, regardless of the sales price of a product.
This formula is particularly useful for companies that sell dozens – or even hundreds – of different products. Assume that an ironmongers shop earns a 15% profit margin on a $5
Use profit margin to adjust the sales mix for products that you sell, so that you can increase your total company profit.
#4 Accounts Receivable Turnover Ratio
No business can survive unless it can collect sufficient cash to operate, and this ratio measures how quickly a firm collects cash from credit sales. The higher the ratio, the more better.
The ratio is defined as (Net credit sales / average accounts receivable).
The goal is to increase the numerator (credit sales) while minimising the denominator (accounts receivable). In a perfect world, a business can increase credit sales to
#5 Inventory Turnover Ratio
In a similar way, the inventory turnover ratio reports how long it takes a firm to convert inventory into cash. For most companies, the biggest use of cash is accounts receivable, inventory – or both.
This ratio is (cost of goods sold / average inventory value), and the goal is to generate the highest ratio possible. The strategy to collect more cash is to maximize
#6 Current Ratio
The last ratio is the most simple, but may be the most important metric for your business in the short term.
The current ratio is (current assets /current liabilities), and this ratio measures your firm’s ability to generate cash inflows to pay bills over the next 12 months.
Current assets are cash, and assets that will be converted into cash within 12 months, which include accounts receivable balances and inventory. Conversely, current liabilities are bills that must be paid in the next 12 months, including accounts payable.
Your goal is to maintain a ratio of at least 1.0, which means that you have sufficient current assets to pay current liabilities. If the ratio is lower than 1.0, you may have to borrow funds to operate over the next 12 months.
Simple, But Powerful
These metrics may seem simple, but they are powerful tools to help you make informed business decisions. Take a look at these six metrics every month, and make improvements to your business.
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About the Author
Paul Jarrett founded Renaix in1997. He studied Management before completing an MBA and brings to his recruitment activities considerable experience and an extensive network of global contacts. In addition to roles in financial line management and audit, he is also responsible for search and general management assignments.