Measuring financial performance.

Hi, I’m Bron Lawson from Westpac’s Davidson Institute here to talk to you about ‘Measuring financial performance’. Now it’s been my experience that many people go into business with a passion for what they do or sell, but they often have little or no formal financial management training – which means, that this part of the business is often left up to someone else to take care of.

It’s also been my experience that with just a little more understanding of the numbers, business owners are able to make more effective and confident decisions in the day to day running of their business.

Let’s quickly recap on the Financial Statements that we had a look at in the previous video ‘Understanding financial statements’, because this is where we are going to source the information to help us measure financial performance.

Firstly, the Balance Sheet, which if you recall is simply a statement, or snapshot, of the financial position of a business at a particular point in time. It shows all the Assets that a business owns and where the money came from to acquire those Assets – namely Liabilities and Net Worth.

On the screen we have the Balance Sheet for Anna’s Guest House and Gift Shop that shows the business has grown rapidly over the past few years – acquiring Assets and taking on more Liabilities. The Income Statement then shows us the financial performance over a period of time – recording the Income earned, the Expenses incurred to earn that Income, and the Profit or Loss that the business has made.

The Income Statement also shows us that Anna’s Guest House & Gift Store has grown its Sales rapidly over the past few years, but that her Profits are not growing. We’re going to delve a little deeper today and use some financial ratios to measure more effectively Anna’s financial performance to help identify what might be causing Anna’s declining profitability.

Now, don’t be alarmed by the thought of ratios because they really are quite straightforward. They simply compare one number with another to tell us a story. Just like the stats for your favourite sport team. There are literally thousands that you could use to measure performance but the ones I am going to show you today are the key measurements for most businesses.

Firstly, we are going to start with the Financial Operating Cycle model. Which helps show how money flows through a business and illustrates for us the relationship between the Balance Sheet and the Income Statement. Then cash flow is absolutely critical for any business, so we are going to have a look at the Working Capital Cycle and measure how efficiently the cash is flowing in the business.

Then finally we’re going to put our measurements into a scorecard to see how efficiently the business is performing from a financial perspective.

Starting with the Financial Operating Cycle. The Financial Operating Cycle is a cycle that operates in every business, no matter the size, industry or location, and when a business owner understands how their business’s Financial Operating Cycle works, then they’re much better informed and can make more effective financial decisions.

Now imagine for a moment that we’re just starting out in business. We break open the piggy bank and put as much money towards the business as we can. Our contribution to funding the business is called our Equity, or Net Worth. This is money from our own pockets. We combine that with money that we borrow from other people, they are called our Liabilities.

And together, our money and the money that we borrow make up all the funding that we have available to operate our business, and we operate the business by purchasing Assets.

Now we use those Assets to generate Sales. Then we have a series of Expenses which, if managed well, then leaves us with a Profit. And this is where I find most people stop … Profit is their one measure of success. However, the next step is to consider how that Profit can be used to drive even more successful outcomes.

In effect, our Profit serves three masters within the business. Firstly, it serves the business by helping us purchase more Assets. Secondly, it serves our Creditors by helping us reduce how much we owe them, and finally, it serves us as the owners and investors in the business, by paying us a return on our investment.

By understanding this flow of funds through a business we can see that everything is interconnected. Now as you may have recognized across the top of the diagram is the Balance Sheet and, on the left, here, the Income Statement and we can see how the two are inter-related. I sometimes refer to this as the engine-room of the business.

You know the engines need to be kept turning over smoothly and efficiently to create a sustainable business. So, it makes sense then that we would want to know how efficiently this cycle is turning over … and this is where ratios can really help us.

To measure how efficiently our Financial Operating Cycle is turning over, we want to look at: How efficiently have I funded the Assets? Is there more of my money invested in the business or am I more reliant on creditor’s money? Then, how efficiently am I using these Assets in generating my Sales? How effectively am I turning those Sales into a Profit?

And then finally, how does this return stack up in terms of a return on the money that I have invested in the business? So, let’s start with “How efficiently have I funded the Assets?” or the Debt to Worth Ratio.

This ratio compares the amount of Net Worth, the owners’ money, with the amount of Liabilities, the other people’s money. Having the right balance here should mean that the owners are getting a reasonable return on the funds they have invested in the business without taking on too much risk, and having the added costs, by relying too much on debt.

It’s calculated by dividing the Total Liabilities by Net Worth. Now in Anna’s case this is $400,200 divided by $260,100, which gives us a Debt to Worth ratio of 1.5. Fantastic! But is it? What is this actually telling us about the business?

Let me introduce you to a sentence that will become your best friend when talking about ratios. It’s a sentence that helps make sense of the story the numbers are telling you. The sentence goes …‘For every $ of bottom, there is x of top’. Let me repeat that … ‘For every $ of bottom, there is x of top’.

Now let’s apply this to the Debt to Worth ratio … For every $ of Net Worth (what’s on the bottom), there is x of Total Liabilities (what’s on the top). Applying that to Anna’s ratio, it tells us that for every $ of Net Worth there is $1.50 of Liabilities. Or, if you like, for every $ the owners have invested, they have borrowed $1.50.

Now taken in isolation, this is probably a reasonable level of Debt to Worth. But should it get too much higher, this would indicate that the business is becoming more heavily reliant on debt which increases the level of risk. If it gets much lower, you might have to ask what opportunities the business may be missing out on by not borrowing more.

The next ratio we’ll look at is the Sales to Assets ratio which looks at how efficiently Assets are being used to generate Sales or Income. Now many businesses have significant $$’s tied up in Assets. Given this money could perhaps be used for other purposes, it’s really important to ensure that it’s being used as efficiently as possible.

To calculate the Sales to Assets ratio, you simply divide Sales or Income by Total Assets. Now in Anna’s case this is this $1,520,000 in Sales, divided by $660,300 in Assets, which calculates out to 2.3. Now again, let’s apply our little sentence that will help tell the story … for every $ of Assets there is $2.30 of Sales.

So, is that result good, bad, or indifferent? Well for this ratio, that’s going to depend on the industry … you know some industries, such as agriculture, manufacturing or mining, require a greater investment in Assets … in which case this ratio becomes even more important. So, to understand whether this is a good result for Anna you would need to look at benchmarks for the industry or perhaps look at her own past performance … which we are going to do a little bit later on in this video.

The next ratio we’ll look at, measures the business’s ability to turn Sales into Profit … or the Net Profit Margin. Many businesses concentrate on increasing Sales, however without ensuring that you’re continuing to make an acceptable Profit margin, this would seem to be a pointless endeavour. We’re measuring this today at the Net Profit level, but it’s also important to measure at the Gross Profit level.

So, the ratio looks at the amount of Profit in relation to the Sales and is calculated by dividing Net Profit by Sales. In Anna’s case there is $44,900 of Net Profit, divided by $1,520,000 of Sales, giving us a Net Profit Margin of 2.9%. Or, using the sentence, for every $ of Sales there is 2.9c of Net Profit.

Again, is this good, bad, or indifferent? Well, that’s going to depend on the industry and the size of the business. Use benchmarks, targets, and trends to establish if the business is operating effectively in this regard. The final ratio we are going to have a look at today in relation to the Financial Operating Cycle is the Return on Investment … that is, what return am I receiving on the money that I have invested in the business?

This is calculated by dividing the Net Profit by Net Worth. That is, the amount of money the business is making, divided by the owners’ investment. In Anna’s case this is $44,900 divided by $260,100 which produces a result of 17.2% … which of course means that for every $ of Net Worth there is 17.2c of Net Profit, or, if you like, Anna is making a 17% return on her investment.

So, is this good, bad, or indifferent? Well, there’s a number of different considerations that come into play here. Similar to the other ratios, you should always check if this is in line with industry benchmarks and see how the business is trending over time. But in this case, you could also see what return could Anna achieve if she invested her money elsewhere?

The way interest rates currently stand, Anna would be lucky to get a 3% return on that money in a savings account or term deposit. So, it certainly stacks up in that regard. But there is something else to bear in mind, and that is, in the bank, Anna’s money would be nice and safe, and she wouldn’t be required to exert any effort to get that 3% return.

But how safe is Anna’s money in her own business? That’s what that debt to worth ratio tells us. Remember that was 1.5 or if you like for every $ Anna had invested she has borrowed $1.50, which I said at the time was a comfortable level of debt, so she doesn't have a high level of risk, but she is achieving what appears to be quite a good return.

So, we have used these 4 ratios … our Debt to Worth, Sales to Assets, Net Profit Margin, Return on Investment … to measure how efficiently the Financial Operating Cycle … our business’s engine-room … is turning. But to keep an engine turning over it needs fuel … which is exactly what cash is for a business. Keeping working capital flowing will help fuel the engine so let’s look at how we can measure cash flow.

To better understand how cash flows through our business we’re going to use a model called the Working Capital Cycle. Here’s how it works … We start off with some money sitting in the bank account. However, money sitting in your bank account is not much good to you. You want to use that Cash to make Profits, so we use this money to buy something that we can sell, and in this case we are going to but some Stock.

The Stock comes in and we fill up our store, or our warehouse, and then look to sell this Stock. Once we’ve sold the Stock, we issue an invoice and end up with things called Debtors or Accounts Receivable. It’s only when we collect this Debtor that our $, plus hopefully some Profit, comes back to our business and the cycle is complete. The aim with this cycle is to keep it turning as smoothly and swiftly as possible!

Each time this cycle goes around is called a ‘turn’. We’re going to measure these turns in days, because we know that days are time, and time is money. Now, I must say, not all businesses are the same. The retailers out there are looking at this and saying, “hold on a second, I get everything in cash and credit cards I don’t have Debtors” and you would be absolutely right.

Your cycle just goes from Cash to Stock and back into Cash. That’s a little bit simpler, but the premise is still the same … turn it over smoothly and swiftly. Now, I know others of you are saying, “Well hold on a second, I’m a service business. I don’t have stock”. And again, I agree with you, however you have something that acts a little bit like stock.

It’s called work in progress or WIP. Basically, you take on a job from a customer you do all the work for them, and then you send out an invoice. Now while you are doing all that work, before you can send out the invoice, what do you have to pay out? Do you have to pay out wages? Rent? Utilities and so on? Because if you do, then it is using up your cash. Then of course you send out an invoice and you wait for your customer to pay you … more time before your dollar comes back into the business.

No matter what it looks like, whatever business you’re in, you have a Working Capital Cycle. So, it’s really important to understand how the Cash flows through your business and to keep this cycle turning smoothly and swiftly. In terms of measuring how smoothly and swiftly this cycle is turning, we’re going to start by measuring “How efficiently am I selling my Stock? Or, on average, how many days does it take to sell my stock?”

Then we’ll look at Debtors and calculate “How long does it take for me to collect my Debtors?” so we can see how long it’s taking for our Cash to flow through the business. So, let’s look at Stock firstly. Cash tied up in Stock is Cash that you can’t use for other things, so it’s really important to know how long it’s going to take to convert that Stock into Cash.

We’re going to calculate on average how many times a year the Stock turns over and then convert that into the number of days it is taking. So, to calculate the average turns per year you divide Cost of Sales by Stock … now in Anna’s case this is $1,200,000 divided by $212,200 which gives us average Stock turns of 5.7.

So, Anna’s Stock turns over roughly 6 times per year. Now to convert that into days we simply divide 365 (the number of days in a year) by the number of times it turns, being 5.7, and that tells us that on average it takes Anna 64 days to sell her Stock.

Now whether that 64-days is good, bad, or indifferent will depend on the type of Stock that it is. If it’s fresh seafood then that’s probably not such a good thing, however if it’s not perishable then again it would depend on what others in the industry are achieving and how it compares with Anna’s past performance.

For many businesses, including Anna’s, the sale is just one part of the process. She now needs to collect on the invoices she has issued to her customers before she gets her Cash back. So, how long is that taking? Well to calculate the average number of times Anna collects her Debtors in a year we divide her Sales by her outstanding Debtors.

Anna’s Sales are $1,520,000 and her Debtors $169,400 which tells us that on average Anna collects her Debtors 9 times per year. So how many days is that? Well, 365 divided by 9 is 41. So, on average it’s taking Anna 41 days to collect her Debtors.

Is that good, bad, or indifferent? Again, that’s going to depend on what her terms are. If Anna’s terms are 30 days from the end of month, then 41 days is probably about right. However, if she has 14-day terms, then 41 days collection is not so good.

So, in total, how long is it taking Anna’s Working Capital Cycle to turn? 64 days to sell her Stock; then 41 days to collect her Debtors; means that on average it’s taking Anna 105 days, which is more than 3 months, to turn that Working Capital Cycle.

Think about this though … if Anna’s Cash is tied up in Stock and Debtors for 105 days, what about all the other things she needs to do in those 105 days? You know, pay her staff, pay the rent perhaps, and purchase more Stock. And given the fact that her Sales are increasing then she is needing to purchase more and more Stock. But where is the Cash coming from?

This brings us to our 3rd measure of working capital or cash. How long is it taking to pay the suppliers or trade creditors? So, let’s see how Anna is doing … To calculate the average number of times a year Anna pays her Creditors we divide her Cost of Sales by her Creditors … or $1,200,000 divided by $99,800 … which comes out to be 12 times a year. Then converting that number into the number of days … 365 divided by 12 is of course 31 days.

So, is this good, bad, or indifferent? Well, if she has 30-day terms from her suppliers, then it’s probably ok. But if she’s not collecting from her customers for 41 days, but paying her suppliers in 31 days, then at some point it’s possible that she may run out of cash. So there seems to be a mismatch in terms of timing of payments.

Again, if we have a look at how this compares with her past performance, we’ll be able to see if perhaps these payments are slowing down because she’s running short of cash. Now that we’ve seen how to measure how efficiently our Financial Operating Cycle is turning and how swiftly … or perhaps not … the Working Capital Cycle is turning, the next step is to put these measurements into a format that is relevant to the business so that we can assess the financial performance.

This could be referred to as a scorecard or dashboard. As I said at the outset, there are literally thousands of things that you can measure but the ratios I’ve shown you today will help tell a relevant story about your business. They’re a bit like your car’s dashboard; while the computer measures hundreds of things, your dash only tells you what is relevant for you to know while you’re driving.

… you know, your speed, how far you’ve gone, how much fuel you have and so on. The scorecard we have developed is a bit like that for your business. The measures for the Financial Operating Cycle tell us how efficiently our engine is running, and the measures of the Working Capital Cycle tells us about the fuel or cash availability.

Now looking at them in isolation as they are on the screen, they still only tell part of the story. As I said you could use benchmarks to see how the business stacks up against other businesses or look at the trends to see whether financial performance is improving or declining.

Throughout this video, we calculated Anna’s ratios using the 1st year of data we had available. On the screen we now have the following 2 years, so that we can see if Anna’s performance is improving or declining over time. We said at the outset that her Sales were increasing rapidly but her profitability was declining, so there’s a distinct possibility that her overall performance has declined.

Looking firstly at her Debt to Worth ratio. In year 1 we said that for every $ of Net Worth (money that Anna has invested in her business) she has borrowed $1.50. By year 3 though this has increased significantly. Now for every $ that Anna has in the business; she has borrowed $2.68. Almost 3 times as much! So, this tells us that Anna is becoming much more reliant on debt and that her risk is increasing.

Anna’s Assets also increased over that time but as we can see from her Sales to Assets ratio, she has become less efficient in their usage. In year 1 for every $ invested in Assets she was generating $2.30 in Sales, but by year 3 that has declined to $1.90.

Looking now to her Net Profit Margin, which indicates her ability to turn Sales into Profits, we can see, as expected, that this has declined sharply. In year 3 she was actually only making a third of a cent Profit from every $ of Sales. And there’s more bad news when we look at her Return on Investment as well.

While in year 1 she was making 17.2% on her investment in the business, by year 3 that has dropped to 1.75% return. Now she really does need to question whether this is the best place for her money to be invested.

Then looking at her Working Capital Cycle ratios, we can see that it is taking her longer to sell her Stock, longer to collect her Debtors, and longer to pay her creditors. Her cash flow is suffering too. Now while these ratios might seem to be all bad news, take heart from the fact that at least Anna is now aware of where she can make some improvements to start to turn her business around.

My challenge for you now is to have a look at your business through this new lens. Today we had a look at the Financial Operating Cycle and ratios to measure how efficiently the business is operating, and then the Working Capital Cycle and relevant ratios to see how efficiently Cash is being generated and used. We put all this information into a scorecard that highlighted some areas where Anna can now implement some actions to improve her business performance.

What some of those actions might be is covered in the video ‘Accelerating business performance’. Thank you for watching our video on ‘Measuring Financial Performance’. We trust you found this information useful and helpful, and I encourage you to check out the other resources on the Davidson Institute website to help build your financial confidence. Bye for now.