Is My Business Healthy?

You took that big step and started your own business.  Things have been rolling right along.  You found a location, got everything set up and started building clientele.  You are working hard, enjoying the challenge and have a positive outlook on the future.  But is your business healthy?  Is your profit margin good?  Are you carrying too much debt?  Are your employees effective enough?  Many of these questions can be answered by analyzing your financial statements.

There are standard financial ratios that are used for financial analysis to help you determine and monitor the financial health of your enterprise.  These ratios can also be compared with your industry, region, and business size to gauge your company’s performance against others in the same line of work.

The use of the term “current” in financial statements denotes assets that can be converted into cash within a year and liabilities that will be resolved within a year.  The Current Ratio shows your ability to pay your debts in the coming year.  This ratio is Total Current Assets to Total Current Liabilities.  A healthy Current Ratio is at least 2 to 1, showing that the business has twice as much cash, accounts receivable (money your customers owe you), inventory and other current assets, as it does accounts payable (money you owe your suppliers) and current debt.

The Quick Ratio is like the Current Ratio, but it ignores inventory.  This shows your ability to pay your debts without liquidating (converting to cash) your inventory.  This is important because it takes time to liquidate inventory and there may need to be other liquid assets to cover your liabilities in the short term.  The Quick Ratio is Cash and Accounts Receivable to Total Current Liabilities.  A healthy Quick Ratio is at least 1 to 1, but will be higher in industries that don’t rely on inventory and lower in sectors that maintain large inventories.

The Current and Quick Ratios give an indication of the company’s Liquidity.  Profit Margin Ratios will help measure the company’s profitability.

The Gross Profit Margin looks at the inventory management, pricing and efficiency of the enterprise.  It is Gross Profit divided by Total Sales.  It is not possible to identify a healthy ratio here without considering the industry.  Here are a few examples: the Certified Public Accountants (CPA) Industry over the last five years has shown a Gross Profit Margin of 97%.  The Supermarket Industry, on the other hand, has only shown a Gross Profit Margin of 25% over the last 5 years and the Machine Shop Industry, over the same time frame achieved a 45% Gross Profit Margin. 

The reason for the differences in Gross Profit Margin is the structure of the industry.  For the Supermarket, the cost of inventory and labor are deducted from total sales to arrive at the Gross Profit.  For the machine shop, labor and manufacturing costs are deducted to arrive at Gross Profit.  The accountant, however, has no production costs or inventory to purchase for re-sale, so there are virtually no deductions to its total sales when calculating Gross Profit.

The Net Profit Margin takes into account all of a company’s non-production, non-inventory related costs.  It is Net Profit divided by Total Sales.  This value will reveal if the company is generating enough sales volume to cover these indirect expenses.  A healthy Net Profit Margin is also industry specific.  Service industries with low overhead show higher Net Profit Margins than labor intensive production facilities or large retailers.  Using the same examples we see that the CPA Industry averaged 21% Net Profit Margin over the last five years.  The Machine Shop Sector in the same time frame posted 6% Net Profit Margin and the Supermarkets averaged 2.5%.

There are also Ratios that measure efficiency, one being Inventory Days which shows how long it takes to turn over the items on your shelf.  A lower number means that you are selling your products faster.  This is also industry specific because some industries don’t have inventory, or don’t require as much inventory as others.

Another measure of efficiency is the Accounts Receivable Days.  This tells how long it takes for a company to get paid.  This figure is also industry specific as some companies, like retail stores, do not bill or invoice, but accept payment at the time of purchase.  A Supermarket, for example, only has to wait an average of 1 day to collect outstanding balances compared to a CPA firm which has to wait an average of 30 days to get paid and a Machine Shop which has to wait an average of 47 days to get paid.

There are many more ratios and financial analytics that can be studied to measure the health of your business.  It is important for the business owner to keep accurate records, learn how to evaluate financial statements and identify potential problems along the way.  An English Merchant at the turn of the 18^th century compared the probable success of a merchant who didn’t understand accounting with that of a mariner who had no navigation skills.

It is also important to understand that each specific industry has its own benchmarks.  Your SBDC Consultant can help you calculate and compare your financial analysis with industry averages for your particular geographic region and business size.

The SBDC has 250 consultants and 40 offices in Florida.  The newest addition to the SBDC network is the North Central Florida office.  Our confidential consulting is available at no charge.  Please call us (386-362-1782) if there is any way we can help you start and grow your business.

Mark Yarick is a certified business consultant with the Small Business Development Center (SBDC) in North Central Florida and is hosted by the University of North Florida in the offices of the Suwannee County Chamber of Commerce.