Every Business Should Track Key Performance Measures
TEC Worldwide is an international organization of more than 7,000 business owners, company presidents and CEOs. TEC members meet in small peer groups to share their business experiences and help each other solve problems in a round-table session. The following questions and answers are summaries of recent TEC meetings in Southern California.
Q: I like to keep close tabs on the performance of my business, but sometimes I get overwhelmed by all the data. What are the most important financial indicators to track and how often should I track them?
A: Key indicators vary from one industry to another, but every business should track certain fundamental performance measures. These fall into three basic categories:
* Profit and loss indicators. The P&L; sheet measures your ability to create sales, earn revenue and generate profit over a fixed period of time.
Start by tracking the following: net income (revenue minus expenses), gross margin (net sales minus cost of goods), net operating profit (gross margin minus selling, general and administrative costs), net profit (net operating profit plus income, minus taxes and other expenses), cash flow (earnings before interest, taxes, depreciation and amortization).
* Balance-sheet indicators. The balance sheet measures the assets and liabilities of the company as well as the amount of equity in the business at any given time. Every business should measure the following balance sheet ratios: Current ratio measures the company’s ability to meet current liabilities using total assets. Quick ratio measures the company’s ability to meet current liabilities using only liquid assets. Working capital ratio measures your ability to withstand a short-term reduction in the business. Debt-to-equity ratio compares total liabilities to the amount of equity in the company. Days receivable ratio measures how long it takes to collect the money customers owe you.
* Nonfinancial indicators. In addition to financial performance, businesses also need to track nonfinancial indicators. These include performance measures such as market share, product or customer mix, number of customer complaints and dollars per unit produced, sold or shipped. These tend to vary more than the financial indicators, so experiment with different nonfinancial indicators until you determine which represent the true performance drivers in your company.
For best results in all three areas, use a trailing 12-month total chart (a rolling annual total entered monthly) because it allows you to spot trends over a long period of time.
If you’re just getting started, ask your chief financial officer or comptroller to help develop the indicators until you get a feel for what you’re trying to measure. After that, you can turn the actual report generation over to someone who excels at crunching numbers.
In addition to tracking key indicators internally, it’s also a good idea to measure your performance against other companies in your industry. The best source for that data is the Robert Morris Associates Annual Statement Studies. Your banker should be able to provide you with a copy, or you can research the information on the Internet. In addition to RMA data, your trade group or industry association may also have statistics on your industry.
Q: Several of our competitors recently cut prices, so now my salespeople are pleading with me to lower ours. We have a little bit of “wiggle room” in our margins, but I’ve never believed in cutting prices just to respond to competitors. What would you suggest?
A: Traditional thinking says to stand your ground; that automatically lowering your pricing will only drive down the average market price, and once down, it will never come back. In too many companies, knee-jerk price discounting merely camouflages poor sales techniques. Instead of lowering price, equip your sales force with the training and tools to sell your products and services at higher margins, or hire new sales reps with more sophisticated skill sets.
A more radical approach says that in today’s world, pricing pressures are inevitable; that--thanks to new technologies and global competition--customers will continue to squeeze your margins no matter what you do. If you refuse to lower prices, customers eventually will migrate to the low-cost provider, regardless of how much value you add. Staying profitable in this scenario requires shifting your focus from adding value to reducing sales and overhead costs. It also requires switching to activity-based costing and allowing customers to buy rather than trying to sell them, a subtle but important difference. Most important, this approach demands that you know your margins down to the tenth of a percent and do not accept business where you can’t make a profit.
Which of these models best represents the current state of affairs? The jury has yet to render a verdict. For now, it may depend on your industry and your specific business.
Either way, it can’t hurt to revisit your value proposition to make sure you truly understand what your customers are buying from you and, more important, whether they will pay a premium for that value. If so, you may be able to maintain margins by upgrading your sales force through training, hiring or both. If not, be prepared to reduce your margins or lose customers.
If there is a business issue you would like addressed in this column, contact TEC at (800) 274-2367, Ext. 3177. To learn more about TEC, visit https://www.teconline.com.