5 Critical Numbers - Know Your Numbers Part 2

Numbers to Know

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In order to sustainably grow your business you need to build out a reporting system that will flag problems and identify potential risks. Analyzing the financials of a company with these numbers is something I immensely enjoy and is a critical part to learning the language of business. As you understand what the numbers mean, financial information becomes a history book to help you understand the past and plan for the future.

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In the previous article we talked about making sure you have done the pre-work to know your numbers. This included the 3 step process of tracking your data, organizing your data and mining your data. If you haven't read Know Your Numbers Part 1 yet be sure to check it out at this link.

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After going through the why and the how you are probably wondering, but what numbers should a small business track? Today we will go through some essential numbers from the income statement all business owners should know:

• Gross Margin
• Direct Labour Efficiency
• Operating Expense %
• Pre-Tax Net Profit
• Return On Invested Capital

All of these numbers should be easy to pull from your bookkeeping records and will help with the following:

• Act as warning lights allowing you to know when to dig deeper
• Determine if your pricing is correct
• Managing labour
• Stopping runaway expenses
• Think about your business as an investment

Before diving in there are a couple important details to keep in mind:

• Numbers become more useful when you look at trends over time
• Numbers are rarely useful as a standalone. If there is a potential issue it is important to gain context
• Not all numbers are defined the same by all people so be careful when comparing your numbers with another business

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Gross Margin %

How it is calculated: (Revenue - Cost of Goods Sold) / Revenue.

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What to use it for: Knowing your gross margin % will tell you whether or not your pricing is correct. When you look at this number over time you will likely see points where you didn't keep up with price increases and your gross margin was compressed making it difficult to pay for all your other expenses.

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Pro-tip: Once you have your business running well this number shouldn't change much.

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Direct Labour Efficiency

How it is calculated: Gross Margin / Direct Labour

What it is used for: Your direct labour efficiency will have an upper and a lower bound. If this number is dropping to low you know that you have a productivity problem and need to fix the process or find the underperforming team member(s). If this number is getting to high you will need to look into hiring more staff or giving a raise.

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Pro-tip: Direct Labour Efficiency is a useful number to share with staff to help set goals for performance reviews.

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Operating Expense %

How it is calculated: Operating Expense / Revenue

What it is used for: Overhead expenses are often overlooked, particularly by newer businesses. Your contribution margin (gross margin - direct labour) must be able to cover off your operating costs with room to spare! You want to look at this number at minimum on a quarterly basis and ensure there are no expenses creeping in. Once you have the correct amount of operating expenses to support your enterprise it will be very hard to adjust them anymore.

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Pro-tip: In todays world one expense that can creep in is software costs. The other large one is management labour.

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Pre-Tax Net Profit %

How it is calculated: Pre-tax net profit / Revenue

What it is used for: If your profits are to low your business will struggle. If your profits are high you shouldn't count on that money forever and need to be wary of potential competition. You want to aim for a minimum of 10% profit. Think of 10% as the break-even profit level and aim to get to 15%.

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Pro-tip: Ensure your market wage is included in expenses otherwise this number will be incorrect.

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Return on Invested Capital

How it is calculated: Profit / (Assets - Liabilities)

What it is used for: A business is one of the largest investments you will have. By knowing your return on invested capital you have a number that you can compare against other investments. Return on invested capital tells you that for every $100 you put into the business you will receive $x back.

Keep in mind that when comparing investments you want to account for risk as a GIC is going to be less risky than a small business. The return on invested capital of a small business can be quite high compared to other investments and for good reason, there is a lot of risk and hard work involved! Knowing the return on investment of your small business will help you determine whether you want to reinvest your profits into the business or move them to another investment. It will also allow you to ensure the business is running efficiently.

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Pro-tip: You don't necessarily want to include all assets and liabilities in the calculation. For example if you have significantly more cash than needed the number will be artificially lower.

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Setting Goals and a Reporting Schedule

Using your numbers to guide your business is only good if you make sure to track your numbers and set goals. We recommend that you setup an accounting reporting schedule where you look at these numbers frequently. Here is an example reporting schedule:

Conclusion

Remember these are some of the basic numbers you should be looking at. They won't answer all your questions but will act as warning lights so that you know when to look into a potential problem further. Knowing these 5 numbers will help you read the income statement like a book, showing you what happened and helping you plan for the future. If you want to go even further into what these numbers mean we recommend that you read through Simple Numbers by Greg Crabtree.

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If you would like help analyzing your income statement be sure to get in touch.

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Happy business building!