From Inside the Vault...

The Business Owner's Cheat Sheet: Working ON the Business

Posted by Bill McDermott on Tue, Jan 10, 2017 @ 11:01 AM

2016 is in the books and a new year starts. Many of the clients I start working with are so busy working IN the business, they don’t take a step back and work ON the business. Have you had the experience in your business where you can’t see the forest through the trees? Here’s a cheat sheet of questions to focus on and ask yourself how you’re doing. To work “on” the business the cheat sheet covers 4 areas:

Profitability: How was my profitability in 2016? Was it up or down against budget, against last year, and the last 3 years average? Be sure to look at gross and net profit. Figuring out profitability drivers can be a challenge, but if you raised prices or increased volume either from new or existing products or clients you likely experienced an increase in gross profit. If you cut expenses or added any expenses that had a positive impact on profit, then likely your net profit increased. It’s important to look at the numbers, but also the percentages too. Once you’ve figured out what happened and why it happened, you’ll have some clarity on some strategies you implemented.

Asset quality: How did my inventory move last year? And what kind of job did we do collecting receivables? Did receivables and inventory increase or decrease and were those changes attributable to sales growth or another reason? Are there any stale assets you should write off? Some times when sales are growing, we don’t pay enough attention to the amount of receivables outstanding or whether we should be billing daily, weekly or monthly? For a $5 million revenue company, a one day change in receivables is almost $14,000 that could be sitting in your bank account.

Liquidity: If “cash is king,” the amount of cash in the bank, preferably internally generated, not borrowed, is a good measure of your liquidity. Is cash up or down against last year? If you get accountant prepared financials, there is a statement of cash flows that comes with your balance sheet and income statement. Quickbooks reports call it a cash flow summary. It tells you what part of your business generated cash or used cash and can help guide you in ways to improve liquidity. A good way to measure liquidity is by looking at it in # of days in sales. Using the AR example in the last section, a one day change in receivables is a $14,000 increase or decrease in cash, 5 days is $70,000. A good rule of thumb is anywhere from 5 to 25 days sales in cash.

Leverage: This is the one banks examine closely. Leverage is calculated by dividing total debt by total net worth. This is a measure of how much skin you have in your business versus your creditors. Did your leverage go up or down last year and why? If you look at your cash flow summary you will see some of the uses of cash in your business, in addition to profits, loans are a source of cash to help you finance those uses. Profits are too. Banks seem to start getting heartburn if your leverage is higher than 3 or 4 to 1.

After you’ve looked at these 4 items you are well on your way to working “on” the business and developing a game plan for what strategies and execution you want to focus on in 2017. If you have further questions on working on your business, please contact us and leave a message or email. I hope 2017 is your best year yet!

Topics: entrepreneurship, small business, strategic planning, cash flow, profitability coaching, business owners, growth, profitability, leverage, activity, liquidity, strategy, process, AR, budgeting

The Business Owner's Cheat Sheet: What are my Financing Options?

Posted by Bill McDermott on Thu, Jan 5, 2017 @ 12:01 PM

It seems like there are almost as many lenders with financing offers as there are restaurants, but if that’s the case, why is so hard to find financing for your business?

There comes a time when you stopped doing your own tax return and handling your own legal issues because the issues became too complex and your time became too precious. The same is true with finding financing.

After the Great Recession, new legislation was introduced that made it even harder to borrow money for your business. You need someone to do the vetting for you and knock out the extraneous players that aren’t going to approve your loan.

Here’s a quick cheat sheet that may be helpful to get you pointed in the right direction.

1. Big bank vs. community bank: Do you want the best price or the best relationship? Large banks tend to have a lower cost of funds, so their rates are lower, but they typically don’t deviate much from their lending policy. Community banks typically do have higher cost of funds, but they’re more relationship focused and are willing to go the extra mile to hear your story. Based on what my clients tell me, it’s easier to have a relationship with a community bank banker than with a banker at a big bank.

2. Were you profitable last year and is your balance sheet leverage ratio less than 4 to 1? If the answer to these two questions is no, then it’s unlikely any bank will loan you money this year. They want to see a full year of profits and a balance sheet leveraged less than 4 to 1, preferably 3-1. If you’re looking for a line of credit, skip the banks and contact an asset-based lender that will loan you money.

3. Asset based lenders (ABLs) are willing to loan you money on the value of your collateral versus your balance sheet or income statement. Most will loan you 75-80% of your eligible accounts receivable. Each lender has their own eligibility requirements, which mostly deal with aging and concentrations.

4. SBA loans are made by the banks, but the SBA does offer programs that provide a guarantee to the bank as an inducement to make the loan. SBA 7a loans are used for business acquisitions, among other purposes, and the SBA 504 loan can provide up to 90%, versus the normal 75-80%, mortgage financing for an owner occupied building. There are other programs, but these are the ones used most frequently. There are very specific eligibility requirements for SBA loans, so please consult someone with SBA experience before you make application for a loan that might be ineligible.

5. Non-bank lenders, venture capitalists and private investment are all sources of financing that fall outside the banking and ABL universe, but still require funding. Many transactions do not fit the bank, conventional or SBA, or the ABL box, so these lenders play in that space. The interest rate and fees are typically higher and in some instances, the lender may ask for equity in the business.

Hopefully, this will get you pointed in the right direction. If you have additional questions, please contact us to talk further.

Topics: balance sheet, debt, SBA loan, small business, SBA loans, cash flow, finance, credit, bank loans, income statement, finding financing, banking, business owners, growth, leverage, profit & loss statement, acquisition

4 Tips for Business Planning in 2017

Posted by Bill McDermott on Wed, Dec 21, 2016 @ 12:12 PM

As we close the books on 2016, there are likely some things that went very well and some things you would do differently. We start to look ahead at the possibilities for 2017 and what we might start, stop and keep doing. To get the thought process started, here are 4 things you must include:

People Issues: Almost every client I talk to is concerned about finding the right people for the organization. There are quality and quantity issues. Do I have the right amount of staff? Are they effective and efficient? Is there drama in the workplace? And are my people generally self-starters with little management required? Equally important is culture, training and retention. To get top people, you have to be able to attract the right people.

Strategy Issues: What kind of company do I want to be, the low cost provider or a differentiated strategy? What 3-5 activities differentiate you in the marketplace? Do you have a well-crafted elevator pitch? Who are your core customers and where do you find them?

Execution Issues: The devil is in the details. Are you executing with high efficiency and effectiveness? Execution covers every aspect of the business: sales, operations and finance. What you want to start, stop and keep doing in your business is entirely about execution.

Cash Issues: Growth requires cash, preferably internally generated, but sometimes you have to borrow it depending on the rate of growth. The ability to increase cash is dependent on your ability to shorten cycle times, eliminate mistakes and improve your business model. I had one client this year decide to bill weekly instead of monthly. He shortened his billing and payment cycle time by two weeks and was able to reduce his line of credit balance and save interest expense. Cash can also be generated if you’re able to increase prices and sales volume or reduce costs paid to vendors and overhead.

Focusing on these four areas can make a huge impact on your company’s top line and bottom line next year. Try and pick just one to focus on to start with and then add 1 or 2 more when you see the need.   Here’s to a prosperous year in 2017!

Topics: entrepreneurship, small business, strategic planning, cash flow, profitability coaching, business owners, cash flow planning, growth, profitability, execution, people, strategy, process

5 Things You Must Know About Loan Covenants

Posted by Bill McDermott on Tue, Dec 6, 2016 @ 15:12 PM

We’ve closed several commitments for lines of credit, term loans and mortgage loans for equipment and real estate.   When reviewing your term sheets or commitment letters, after you go through the borrower, loan amount, rate and fees, collateral and guarantor section, you’ll end up at a section called covenants. A covenant is a mutual promise made by both parties, you and the bank. In this section, both parties agree to certain things as conditions of the borrowing relationship. If either party breaks the covenant, then both parties come to the table to discuss what happened and why. Here are five things you must know about loan covenants. 

1. The most common types of covenants are financial covenants. Financial covenants generally fall in to ratios pertaining to the balance sheet and income statement. The most common income statement covenant is called a cash flow coverage ratio, debt coverage or fixed charge coverage ratio. It’s important to understand how this ratio is calculated. It’s mostly, the cash flow of the business (EBITDA) divided by the loan payments made line of credit, term loan or mortgage. Most banks are looking for a 25-50% cushion of cash flow over loan payments, so the ratio is expressed as a cash flow coverage ratio of 1.25-1.50 depending on the lender.

2. The second most common covenant pertains to the balance sheet and is usually a leverage ratio or a debt to worth ratio. This ratio is calculated by dividing total debt by total net worth on the balance sheet. Most banks care about leverage because it shows how much skin in the game the owner has versus his/her creditors. Because the owner has all the upside in the business, banks care if they and other creditors are taking a majority of the risk and have no upside. Generally, if your leverage is much above 3 or 4 to 1, banks may become concerned and could limit your ability to borrow until you get your leverage back in line. It’s common to see at least, one income statement and one balance sheet covenant in your term sheet or commitment letter.

3. The third type of covenants that are common are non-financial covenants. Many banks want annual financial statements within a certain period of time after year-end. If you have a line of credit you may provide monthly financials to the bank including an accounts receivable aging. Most banks will monitor the level of receivables and whether you have any aged receivables or concentrations of receivables that could limit your ability to borrow. Generally, a personal financial statement and personal tax return are part of any financial report covenant requirement also.

4. Many banks will limit the ability to borrow additional funds from another lender as a fourth type of covenant. This is common especially for a business with a lot of leverage. You reduce leverage by increasing net worth without increasing borrowing. There may be situations where borrowing small amounts is in the ordinary course of business. So, it’s possible for you to ask your bank if there’s a maximum amount you could borrow annually without breaking this covenant. $100,000 might be reasonable for a business with $5 million or more in revenue.

5. Changes in ownership and management are the fifth type of covenant banks may require. The bank got comfortable with your loan request based on the majority owners and managers if you have a closely held business. If the owners decide to sell off a significant amount of stock or become absentee owners, the bank may have a different feeling about loaning to your business. They made their decision based on the ability of current management. If there’s a material change, they may feel differently. Before you implement any significant changes in ownership or management, it’s best to get your bank on board and get them comfortable with the reason for the changes and what the changes are.

Let’s agree nobody like surprises. You don’t want the bank to pull the rug out from under you and not renew your line of credit. On the other hand, the bank doesn’t want to be surprised if there have been significant changes in the financial performance of the business or ownership and management changes. Covenants are the bank’s way of saying we don’t want to be surprised. Before you sign your commitment letter, it would be a good idea for you to have a conversation with your bank about how they handle covenant violations if they unexpectedly occur.

Topics: balance sheet, debt, entrepreneurship, small business, small business loans, strategic planning, cash flow, credit, leverage covenant, income statement, loan covenant default, finding financing, loan covenant, line of credit covenants, business owners, cash flow planning, bank covenants, leverage

Budgeting for 2017-How do I Improve Operational Efficiency and Effectiveness?

Posted by Bill McDermott on Thu, Dec 1, 2016 @ 13:12 PM

Many closely held businesses are seeing significant increases in revenue despite slow overall economic growth. With those increases, pressure can be created on people and systems to the point where you’re confronted with finding quality people and investing in systems to support your growth. Those investments of people and systems may have come at significant cost. So, how do you construct your budget and incorporate some changes in it to improve operational efficiency and effectiveness.

Efficiency is defined as “doing things right,” and effectiveness is defined as “doing the right things.” What things should I be looking at in my budgeting to accomplish this?

Budgeting in a Service Business

If you’re a service business, you’re not selling or manufacturing a product. So your budget has revenue and cost of services (labor). You have direct labor (billable) and indirect labor (not billable). I’ve talked in recent blogs about a net multiplier and labor utilization rates.

Net multiplier is the markup between direct labor and revenue and is calculated as (revenue/direct labor). Of course, you’d like for your markup to be as high as the market will bear. Part of this will be based on whether your service is viewed as a commodity or if there’s high perceived value. I’ve seen a range of net multipliers as low as 1.2 and as high as 2. 

When setting your budget for 2017, calculate what your net multiplier has been historically to give you a benchmark to budget against. If you’re budgeting a multiplier of 2 when historically you’ve accomplished 1.5, then you have to ask yourself the question of how you expect to accomplish that.

Budgeting in a Retail or Wholesale Business

If you’re selling a product then your markup, which is the difference between what you bought and sold the product at, is your best way to accomplish operational efficiency and effectiveness. Your markup is calculated by taking the cost of the product, $100 for example, and increasing it by a percentage. If you sell that product for $150, then your markup is 50%.

Generally a 1% increase in what you sell the product for or a 1% decrease in what you bought the product for can have a 10% improvement in your overall net profit margin after overhead. When’s the last time you had a price increase? Has your supplier given you price increases that you haven’t been able to pass on which have detracted from your overall gross profit margin. To improve efficiency and effectiveness, consider finding another supplier that will sell the same quality for less or increase your prices.

When setting your budget for 2017, check your historical markups and see if you’re trending positively or negatively. The ability to increase markup may be in part a function of competition, whether your product is perceived as a commodity or other factor. However, if you budgeting for a markup of 75% when historically you’re trending close to 50%, you have to ask the question as to how you’re going to achieve a 25% reduction in cost or increased prices or a combination. It may not be reasonable given competition or other factors.

Budgeting in a Manufacturing Business

A manufacturing business has an element of labor and materials embedded in their cost of goods sold. Historically, a car manufacturer used assembly line of materials and labor to put the cars together. Now in a world of automation, many manufacturers are using robotics in lieu of labor, in part to control costs and improve efficiency. Manufacturers also look at markup similar to wholesaler and retailers. However, a manufacturing business is usually an asset intensive business because it takes a lot of fixed assets, like robotics and a physical plant to manufacture the product. So, markups are sometimes slimmer.

Because margins are slimmer, a 1% improvement in revenue or a 1% decrease in cost of goods sold can have a higher impact on a manufacturer than a retailer or wholesaler. Manufacturers are looking to offer incentives as a way to increase prices. 0% interest for car loans is one way that car manufacturers do this. They subsidize the cost of the financing and build it in to the price of the car. 

Using robotics or increased automation has been an attractive way for manufacturers to reduce costs recently. While it usually requires a large investment in fixed assets initially, over time the cost per unit manufactured goes down due to the improved efficiency and effectiveness.

When budgeting for a manufacturer, sales rules apply. Look at your historical markups and use that as your initial factor for determining future gross profit. 

Budgeting is part science and part art. However, a good starting point is looking at historical markups and net multipliers to determine where to begin.

Topics: entrepreneurship, small business, strategic planning, cash flow, profitability coaching, business owners, cash flow planning, growth, profitability, strategy, budget, forecasting, projections, budgeting

3 Things You Must Know About Acquisition Financing

Posted by Bill McDermott on Wed, Nov 16, 2016 @ 16:11 PM

I have several clients that are involved in business acquisitions. With a sluggish economy, many are attracted to the opportunity to acquire business versus grow organically. If you’re deciding to buy a company, here are 3 things you must know about financing the acquisition. 

1. Many buyers want an asset purchase because they get a step up in the basis of the assets. The difference between the purchase price and the assets is considered goodwill and is amortized (non cash expense) over time. Because goodwill is an intangible asset, the bank will request you collateralize the goodwill with tangible assets like receivables, inventory, equipment or real estate. If the business does not have sufficient assets to fully collateralize the loan (remember the bank has a margin requirement on all assets), then the owner may need to pledge personal assets to cover any shortfall as part of his/her guarantee.

2. Don’t expect the bank to finance 100% of the purchase. Just like buying a building, the bank expects 20-25% equity and they finance 75-80% with their loan. In prior articles, we have talked about leverage. When you borrow 80% and you put in 20%, you in effect are creating a leverage ratio of 4-1 (80/20 = 4), if you put in 25% it’s 3-1 (75-25). Banks get uncomfortable, when leverage is above these numbers.

3. The best bank product to use for a business acquisition is the SBA 7a loan. It’s a term loan for up to a 10 year period, rate is a variable rate that floats with Prime, usually 2.5%-3.5% above Prime. Most banks don’t finance acquisitions on a conventional basis and even if they did the term wouldn’t come close to 10 years, likely 3-5 years because the goodwill. The SBA provides a 75% guaranty back to the bank if the loan is in default and has to be liquidated. There is a fee for the guaranty of about 3% that is paid to the SBA and can sometimes be financed in with the loan. The SBA requires a minimum of 20% equity, 10% of that in cash with the other 10% in cash or subordinated seller financing.

The SBA 7a loan is the bank’s product of choice for any acquisitions that are financed with bank debt. There is a cap of $5 million under this program.

Topics: debt, SBA loan, entrepreneurship, small business, strategic planning, cash flow, collateral, credit, profitability coaching, finding financing, business owners, cash flow planning, profitability, leverage, strategy, acquisition

5 Things You Need to Know About Forecasting

Posted by Bill McDermott on Mon, Oct 31, 2016 @ 11:10 AM

It’s that time of year again when we begin to close the books on the year and look ahead to what the new year might bring. The assumptions you use are critical to your profit and loss and balance sheet forecasts. This is especially true if you will use these projections to attempt to obtain financing or attract an investor. 

Here are 5 things you need to know:

1. Make an honest assessment of how you did with last year’s budget. How did you do at forecasting revenues, gross and net profit? Did your receivables collection period change last year vs forecast? Are your clients paying you a little slower than expected? How about payables? Did your vendors offer early payment discounts that you took advantage of, which reduced cash but improved your profit margin? Were you a little too aggressive on estimating your growth rate or did you forecast less expenses than you actually had? Look for tendencies in your forecasting to gain insights on things you can do to improve this year. 

2. Forecast from the bottom up, not the top down. Many of us start with revenues and forecast down to profit. I want to suggest that you consider forecasting profit first then work your way up to revenue. I’ve hear it said, “It’s not how much you make (revenue), but how much you keep (profit).”

3. Look at your historical performance over a period of time. Three years is preferable. If your historical sales growth rate is 10% for the past three years, it probably doesn’t make sense to forecast 20% or 5%. Also, if your historical margins for gross and net profit are 30% and 5%, it may not make sense to change those for forecasting purposes unless you’ve had some significant changes in your business to warrant those changes. In the same way, if you collect your AR in 40 days historically and pay your payables in 35 days, changing those terms to forecast your balance sheet probably doesn’t make sense. Also, if you plan to buy fixed assets next year, make sure you include the changes in fixed assets and any related loan.

4. Research industry norms and standards to see how your company is performing in comparison to your peers. If you’re struggling with your revenue forecast even after looking at your historical performance, contact your trade association or your bank to see if they subscribe to any trade journals that provide industry forecast information. I have a couple of clients in the concrete business and their industry is projected to grow at a 7% growth rate nationwide, very high considering GDP growth for the economy.

5. Document your assumptions on your forecast. It’s important to put your assumptions on the forecast so any user can understand what your assumptions were behind the numbers.

Many business owners will have several rounds of assumptions before they end up with a forecast they’re comfortable with. Remember it’s important to forecast not only your income statement, but also your balance sheet and cash flow statement. You’ve heard me say before that the balance sheet is more important than the income statement and it’s important to see if you have any negative cash flow months so you can predict any amount of borrowing on your line of credit that will be required.

Topics: balance sheet, entrepreneurship, small business, strategic planning, cash flow, profitability coaching, income statement, business owners, cash flow planning, growth, profitability, profit & loss statement, strategy, forecasting, projections

Do Your Sources and Uses of Funds Match?

Posted by Bill McDermott on Fri, Oct 14, 2016 @ 11:10 AM

The title of this article may be a little confusing, but let me de-mystify it if I can. In your business, you need funding for certain things. You might be buying a business, a building, a piece of equipment or just need funds to meet operating expenses including payroll. These things I just identified are all uses of funds. So what’s the funding sources of these uses? Often many business owners fund these out of cash flow, some will take out term loans, mortgages or lines of credit.

It’s important for these sources and uses to match. By that, I mean long term uses (purchase of long term assets) like a business, a piece of equipment, or a building should be financed with long term sources of funds, a mortgage or term loan. Short term uses like operating expenses or funding payroll should be funded with a bank line of credit, a short-term source of funds. The reason for this is most lines of credit are repaid from short term assets like accounts receivables or inventory.

Your line of credit will typically have a use of proceeds section that stipulates that the line is to be used for temporary working capital, short term uses. It will also have a 30-day annual payout which means that the line must be at 0 for 30 consecutive days. If you’ve used the line for a long-term use like purchasing equipment for example, you may have unintentionally violated the use of proceeds agreement, but you won’t have the cash flow to repay the line in full for 30 days. You run the risk of the bank declaring a default because you have violated the commitment from the bank’s point of view. On long-term sources of funds, you typically try to match the amortization of the loan to the book depreciation schedule of the asset, 3-7 years for equipment and 15-25 years for real estate.

Also, you wouldn’t take out a 3 year term loan to fund payroll for last month, which would be a short term use with a long term source. You end up paying interest over three years for one month’s worth of payroll. You end paying more interest than is necessary.

Sometimes as business owners we get busy. We’re juggling multiple priorities and we don’t pay attention to things like this. Sometimes, the path of least resistance is the one we take to get it done. Therefore, we may have a situation where we have unintentionally shot ourselves in the foot if we funded a long term use with a short term source or vice versa. Take time to review your balance sheet and cash flow statement to be sure that your sources and uses of funds for the last 12 months match and if they don’t consider taking steps to correct the situation.

Topics: balance sheet, debt, entrepreneurship, small business, strategic planning, cash flow, finance, profitability coaching, line of credit covenants, business owners, cash flow planning, profitability, line of credit, term loan, strategy

3 Financial Blind spots Prohibiting Growth in your Business

Posted by Bill McDermott on Mon, Sep 26, 2016 @ 15:09 PM

Have you ever had the experience cruising down the Interstate, you put on your turn signal and start to changes lanes, suddenly you hear a loud horn and swerve back in to your lane to avoid an accident. You had a car in your blind spot. Thankfully, you were able to avoid a collision.

The same is true in business. You’re about to make a change. Maybe it’s a new product or a new market. Maybe you’re thinking about hiring that person you’ve been putting off for a while. Maybe you have an opportunity to buy a business that’s right in your sweet spot. When you’re making these types of decisions it’s important to know what is lurking out there in your financial blind spot and how can you avoid an accident in your business that could cost you significant time or money.

  1. New Products and/or Geography: You’ve probably heard the saying “count the cost” before doing something. New products or geographic expansion typically require people to sell, manufacture and distribute goods and services. It would be nice if you could expand without adding people, but it’s unlikely. It’s a good idea to create a projection of how long it takes the new product/market to get to breakeven and then turn profitable. The total cost to get to break even is your investment and the profit you make will be the return on that investment. Is it worth it? 
  1. Your Mix of Revenues is Changing: Not all product/services carry the same profit margin. Your gross margin is either creeping up or down and you haven’t noticed that your mix of revenues has changed. It’s important to understand what’s driving your changes in gross margin by breaking out your gross profit by product/service. You could be increasing volume in different products/services vs in the past or maybe you had a price increase in certain products or services. Whatever the change is, it’s not only important to understand what’s going on, but why. 
  1. Your Overhead is Creeping Up: When times are good and the business is expanding, we tend not to look too hard at our overhead and when those expenses start creeping in to our net profit margin, sometimes we just don’t notice. It takes a significant downturn to get our attention. As part of monthly business review, take a hard look at your net profit margin and determine what’s going on with your operating expense. Have you added people, that aren’t creating efficiencies that improve your profit margin? Are insurance costs rising and you haven’t been able to pass on those increased costs to your customers? Have you spent more than normal on marketing, which haven’t really paid for themselves? Looking at each significant expense category and comparing it as a percentage of revenue over time can give you an idea as to which expenses are increasing. Again, it’s also important to know what has increased and why it increased.

Topics: entrepreneurship, small business, strategic planning, cash flow, profitability coaching, business owners, cash flow planning, growth, profitability, activity, execution, liquidity, strategy

5 KPI's to Measure the Productivity of your Business

Posted by Bill McDermott on Wed, Sep 14, 2016 @ 12:09 PM

I’m a big believer in managing your business using your balance sheet first, then your income statement.   However, simplifying that by using KPI’s (key performance indicators) can help you get a quick view of your financial landscape and determine your financial health at a glance. Here’s 5 KPI’s that every business owner should use. These are in no particular order, but they cover profitability, liquidity and leverage.

  • Working Capital KPI: This KPI is calculated by taking current assets- current liabilities. The more current assets you have in excess of your current liabilities, the more liquid you are. If you liquidated all your current assets would you have sufficient funds to handle all your current liabilities and some money left over. The idea here is do you have enough assets to meet your short term financial obligations?

For example, if your current assets total $500,000 and your current liabilities total $250,000 then your working capital is $250,000 (500-250). You have $2 dollars of current assets for every $1 of current liabilities. 

  • Return on Equity KPI: This KPI is calculated by taking net profit/shareholder equity. It measures the ability of the company to generate a profit on each unit of shareholder equity. The return on equity not only provides a measure of your profitability, but also the efficiency of the business. An increasing ROE shows shareholders that you’re using their investment to grow the business.

For example, if you had a net profit of $200,000 and your shareholder equity was $500,000, then your return on equity was 40% ($200/$500).

  • Debt to Equity (Leverage) Ratio is calculated by taking total debt/total net worth. It measures how the organization is funding its growth and how effectively they are using shareholder investments. A high debt to equity ratio is evidence that an organization is fuelling growth by accumulating debt.

For example, if your total debt is $1 million and your total net worth was $250,000, then your leverage ratio is 4 to 1 ($1 million/250,000). You have $4 of debt for every $1 of total net worth.

  • Accounts Receivable Turnover KPI is calculated by taking revenue(annualized)/accounts receivable. It measures the rate at which you collect on outstanding accounts. The problem in maintaining a large bill for a customer is that you are essentially giving them an interest free loan.

For example, if you have $3 million in sales and your accounts receivable balance is $500,000, then your accounts receivable turnover is 6 times ($3 million/$500,000). To convert this in to days, you take 360 and divide it by the turn, 6. With 360/6 = 60 days, this means you have two months of sales outstanding in accounts receivable.

  • Accounts Payable Turnover KPI is calculated by taking purchases (annualized)/accounts payable. This KPI shows the rate at which your company pays off suppliers and other expenses. It’s also important for understanding the amount of cash that your business spends on suppliers during any given period. 

If your purchases total, $2 million and your payables balance is 200,000, then your accounts payable turnover is 10 ($2 million/$200,000) to convert this to days, take 360/10 and you come up with 36 days of purchase in accounts payables.

You might be thinking, once you calculate these KPI, are my numbers good or bad? Great question! You might want to calculate your KPI’s historically (over the last 3 years or so) to see what direction they’re heading. You may also call your industry association to see if they provide any information on industry KPI’s. I had a mentor tell me one time, you have to “inspect what you expect.” If you can’t measure, you can’t manage it. I hope this article was helpful in giving you some focus on 5 important KPI’s.

Topics: balance sheet, debt, entrepreneurship, small business, strategic planning, cash flow, credit, profitability coaching, income statement, business health checkup, business owners, cash flow planning, growth, profitability, leverage, profit & loss statement, activity, execution, liquidity, strategy