A great way to assess the financial health of your business is to use some simple ratios to look at your business performance over the last few years.  This will allow you to see how your business has been tracking.  To get additional value you then need to compare your results with the industry standards; this will highlight whether your business is performing as well as it should or if there is room for improvement.

There are different types of performance ratios depending on what aspect of your business you want to look at.  These include:

1. Profit Ratios – these show the profitability of your business
2. Liquidity Ratios – these assess the ability of your business to pay its debts
3. Financial Ratios – these assess the funding position of your business
4. Efficiency Ratios – these look at the efficiency of your business processes

By monitoring these you can get a good overview of how your business is performing.

Profit Ratios

1.   Gross profit margin

This shows the proportion of profit for each sales dollar before expenses have been paid.  An acceptable margin varies from industry to industry, but in general the higher the margin the better.

Gross profit margin = Gross Profit / Sales : 1.0

2.   Net profit margin

This shows the proportion of profit for each sales dollar after expenses have been paid.  An acceptable margin varies from industry to industry, but generally the higher the margin the better.

Net profit margin = Net Profit / Sales : 1.0

3.   Gross profit vs net profit

The difference between the two can easily be seen on your profit and loss statement.  Your gross profit is your sales minus your cost of goods sold, but does not factor in your business operating expenses.  Net profit is a truer indication of your profit, as it factors in both your cost of goods sold and your operating expenses.

4.   Return on investment (ROI)

The ROI shows how efficient your business is at generating profit from the original investment (equity) provided by the owners/shareholders.  Lenders will also be interested in your ROI to help them determine the financial strength of your business.

ROI = Net Profit / Owner’s Equity

Liquidity Ratios

1.   Current ratio or working capital ratio

This calculates your business’ liquidity — i.e. how quickly your business can convert assets into cash for the purpose of paying your current bills/liabilities. This ratio is a good measure of the financial strength of your business.  For example, a ratio of 1:1 means you have no working capital left after paying bills. So generally, the higher the ratio the better off your business will be.  Lenders will also be interested in your current ratio to help them determine your capacity to repay a potential loan.

Current ratio = Current assets/ Current liabilities : 1.0

2.   Quick ratio

This “acid test” ratio is similar to the current ratio described above, except that it excludes inventory, which can sometimes be slow moving.  This ratio provides a much more conservative measure of the liquidity of a business.  For example, a ratio of 1:1 means you have no working capital left after paying bills.  So generally, the higher the ratio the better off your business will be.  Lenders will also be interested in your quick ratio to help them determine your capacity to repay a potential loan.

Quick ratio = (Current assets – Inventory) / Current liabilities : 1.0

Efficiency Ratios

1.   Debt to equity

This shows you what type of financing your business is more reliant on – debt or equity (private investment).  A ratio of 1:1 means you have an equal proportion of both debt and equity.  In general you want a mid to low level ratio.  The higher the ratio, the higher risk your business is to lenders.

Debt to equity ratio = Total liabilities / Total equity : 1.0

2.   Loan to Value (LVR)

If you are considering taking out a loan to buy property or an asset, the LVR is the loan amount shown as a percentage of the market value of the property or asset.  The ratio helps a lender work out if the loan amount can be recouped in the event a loan goes into default.  The percentage lenders are willing to accept will vary, but the lower the LVR, the better.

LVR = (Loan amount / Property or asset value) * 100

If you would like us to assess your business performance and identify opportunities for you to improve it, then call us today on 08 9204 3733 and arrange an obligation free review.

This month we are focusing on things you can do to give your business a quick health check and improve your business performance during this financial year.  To start,  let’s look at ways you can reduce the costs involved in running your business.

When you are caught up in the day to day running of your business it’s easy to lose track of costs or leave small direct debits in place even though they are no longer required.  These may seem inconsequential in the overall scheme of things, however they can quickly mount up to a considerable amount over time.

So take the time to do a quick cost review and ensure you are keeping as much money in your business as possible.

Cutting costs can be a quick and easy way to immediately improve the profitability of your business.  Focus your efforts on identifying and eliminating costs that are clearly a waste of your resources, but be careful as indiscriminate cost cutting can lead to a loss in production quality.  This could also lead to poor staff morale if they fear being made redundant or no longer have the necessary tools they need to do their job efficiently.

Planning for effective cost control

The first step towards reducing costs is identifying your major cost centres.  These are likely to include:

• Production
• Purchasing
• Sales and marketing
• Financing
• Administration
• Facilities maintenance

Trial new ideas

You might find it’s difficult to anticipate savings without actually implementing new systems and processes.  Remember that any changes you make don’t need to be permanent.  If you aren’t sure if a cost saving measure is suitable for your business, consider trialling it for a few months then assessing the results.  This way, you’ll soon get an idea of the real cost savings without having to commit long-term to new processes or changes.

Any new processes or systems should be benchmarked and frequently revisited to ensure they are still suitable for your business.  Consider asking staff for feedback about any changes to make sure there are no hidden problems that could be costing you more.

If you are in doubt about any potential changes, consider seeking professional advice from an accountant, industry association, or business mentor.

Quick savings

You might be surprised to find that significant savings can be made without having to worry about quality and performance being affected.  Here are the most popular ways to trim costs without making radical changes:

• Eliminate unnecessary costs – start with waste reduction, heating and utilities charges.
• Reduce inefficiency by identifying manual tasks that could be computerised or completed less frequently.
• Avoid frequent, small orders that cost more than larger orders and take additional time to complete.
• Reduce travel expenses by booking air travel earlier and using cheaper accommodation on business trips.
• Find alternatives to high priced suppliers or negotiate better payment terms or discounts on purchased goods.
• Revise your credit policies to encourage prompt payment.
• Brainstorm quick cost saving ideas with your staff – they might have some useful suggestions you may have overlooked.

Significant savings

Once you have identified your major cost centres, you may want to investigate potential ways to save money by changing existing processes.

Some of the most common opportunities are listed below, but before adopting any changes you should be aware of any potential damage to your core business activities.

• Cut payroll costs by outsourcing non-essential activities.
• Redesign your existing processes to eliminate duplication and cut time wastage.
• Make use of current technology or latest industry thinking.
• Agree to long-term supply contracts or guarantee a minimum purchase amount to secure better terms.
• Trim back or revise your current product offering and remove poorly performing products.
• Form strategic alliances with other businesses to buy larger volumes.
• Consider subletting office space or relocating to a more cost efficient location.

There may also be other costs such as long-term, fixed rate business loans or fixed price contracts for raw materials that you may be able to reduce when these are up for renewal or tender.

Pitfalls to avoid

Reducing costs can have a negative effect, so you’ll need to be sure that changes will not compromise your operational performance.

Some common pitfalls include:

• Over-dependence on one supplier could put you at risk if your supplier fails.
• Reducing your marketing budget could affect your marketing strategy.
• Tighter control of business finances could leave you without a safety margin if cash flow becomes tight.
• Cutting short-term costs such as training, research and development or advertising can lead to long-term weaknesses.

Employee costs

Reducing employee-related costs is generally risky and counterproductive in the long term.  Reducing costs such as staff training or meeting times could lead to poor staff morale and reduced productivity.

Changing an employee’s terms and conditions can also create legal issues in some circumstances, so it’s always a good idea to get expert advice before making a decision.  Making employees redundant could bring short-term costs and the risk of possible legal proceedings.  It may also contribute towards low morale.

These problems can be minimised by maintaining clear communication with employees.  Introducing cost savings through improved practices and procedures will require a degree of employee ‘buy in’, so it’s important your employees are aware of why you are making changes.  Employees may need additional training and support during these periods.

If you would like help to identify potential cost saving opportunities within your business, we can provide an obligation free review of your business.  Cutting costs is one of the quickest and easiest ways to improve your profitability, so call us today on 08 9204 3733.

As we discussed last week, pricing your product is an important factor in making sure your business makes a profit.  If you want to work out your pricing for profit there are a few key factors that must be taken into account.  The price must cover all costs but also be acceptable to customers if you are going to sell your product.  There are a number of ways to arrive at the price to charge customers. Regardless of which method you use, you’ll need to know what it costs to supply your product to be sure you’re able to operate at a profit.

Work out your costs

The first step is always to work out what it costs you to supply the product.  To do this, you’ll need to work out the direct and indirect costs (also known as the fixed and variable costs) involved in producing and supplying your product.

It can be a good idea to ask your accountant or financial adviser to check your figures to make sure you haven’t overlooked any important costs.

You can then go on to work out a price based upon your preferred pricing method.  We have outlined the major pricing methods below.

1. Cost-plus pricing

Add on a fixed percentage of the cost price to provide you with an acceptable level of profit.  Manufacturers will often add between 40 and 50 percent to the cost price of a product to arrive at the selling price.  So, if it costs $20 to produce an item it will sell for between $28 and $30.

Cost-plus pricing works best in a market where there is a lot of price competition and high sales volumes.  Be aware that this model is based on input costs that don’t include other factors such as customer perception of quality, what the market would pay for the product and what your competitors are charging.

2. Value-based pricing

Price your product or service based upon what you believe customers would be prepared to pay for the product. The value-based model gives you the flexibility to arrive at a price that is higher than the cost-plus model, allowing you to charge for the perceived value of your product.

Value-based pricing works best in a market where you have a distinct advantage over your competitors and where you have established customers who are prepared to pay a premium for your product – either because of quality, being first to market with the latest technology, or providing organic or eco-friendly options not provided by your competitors.

3. Competitor-based pricing

This is where you price your product relative to the price your competitors are charging.  If you believe you have a market advantage and people perceive your product as superior, you might decide to set your price slightly above that of the highest price charged by your competitors.

If you want to be perceived as offering good quality at a reasonable price, you might pitch your product price at around 10 to 20 percent below your market leading competitors.  And if you want to be seen as offering value for money, you might pitch your price around the level, or just below that, of the lowest prices charged by your competitors.

4. Prestige pricing

If you are first to market with a new product or have a well known brand, you can consider prestige pricing.  Much like the value-based pricing model, you charge what you think your customers will pay, adding a premium for the prestige associated with buying a top brand or cutting edge technology.

Most small businesses are not likely to use this pricing model, but you can consider it if you develop a leading brand or develop a market leading product.

Pricing for profit and pricing your product correctly is a major factor in the success of your business and no matter what model you use it’s essential that you review your pricing on a regular basis to ensure you are effectively covering your costs and making a reasonable profit.

Let’s face it, running a business is hard, time consuming and stressful, so you want to ensure you are getting a reasonable return on your investment.  If you would like assistance, then the team at BSN & Co would be happy to help.  Just call us on 08 9204 3733 and we can meet for an obligation free review.

Are you making money or just covering costs?

It’s a good idea at the start of a new financial year to undertake a business health check to ensure that your business is ready for the year ahead and is well placed to achieve more success and better profits.

A good place to start is to take a look at your business break even point now.  Your break even point is the point at which you are not just working to cover costs but are actually generating a profit and putting some money in your pocket for all the hard work you do.

This is usually something businesses do when they first start out, but they often forget to keep an eye on their figures.  Over the years the cost of running a business can creep up due to price increases and if you don’t monitor the effect of this on your bottom line and you simply absorb the cost, it can have a negative impact upon your profit margin.

If you don’t review your pricing you may find you are actually making less per sale than when you started out in business.  This means that you have to work harder and longer and sell more just to maintain your profit!  It is for this reason that undertaking a business health check in Perth is so important.

Stop giving away your profit

Review your break even point and identify how much money you need to generate today to cover all your costs.  By really understanding all of your business numbers you can identify opportunities to improve your profit and business performance, plus it assists you to make informed decisions about your business, helping you to work smarter not harder.

How much does it cost to open your doors?

When running your business you have 2 types of costs you need to cover.  Fixed costs like rent or mortgage payments, interest on debts, phone and Internet connections do not change no matter how much you sell.

The other type of costs are variable costs.  These increase or decrease in line with your sales volumes and include materials and supplies, freight, commissions or extra labour to produce the goods.

Your break even point is the point at which your business generates enough income from sales to cover both the fixed and variable costs.  So each sale needs to cover all the variable costs and the sale price needs to cover all of these and a bit extra which becomes profit.

Manufacturing business – calculating gross profit

Say your business makes wooden garden benches and you want to work out the gross profit margin on each bench.  This is the difference between the selling price and its variable production costs.  For example:

You decide a realistic market price for each bench is $120

Labour cost ($40) and materials ($25) for each bench totals $65

The difference between $120 and $65 is your gross margin of $55

What do you want from the business?

Calculating sales required

To find out how many benches you have to sell each year to meet your income goal, divide the required $100,000 annual gross margin by the gross margin per bench of $55.  The result shows you need to sell 1,818 benches a year.

How does that average out per week?  If you decide you want at least a four week break every year, divide 1,818 by 48 weeks and your break even sales target is 38 benches a week.

Do you think you can sell an average of 38 benches a week?  Remember, this is break even only.  It will pay your required salary, but there’s no extra profit margin to grow your business.

Service business – calculating gross profit

In a service business you’re selling your time, so you can take a slightly different angle.  Let’s presume the goals remain similar and you’re working alone, except for one part-time person doing office tasks so you can spend more time with customers.  Their salary adds $20,000 to your overhead costs.

What do you want from the business?

Time available

You work 5 days a week for 48 weeks or 240 days a year.  Subtract 15 days for sick leave and public holidays – this gives you a total of 225 working days.

You work 8 hours a day but allow 3 hours for travelling and preparing quotes and tenders.  This leaves 5 billable hours a day.

Hourly charge-out rate

Now you’re ready to calculate your charge-out rate.

Billable hours a year = 5 x 225 working days which totals 1,125 hours.

Divide your goal of $120,000 by 1,125 billable hours and your minimum charge-out rate per hour is $107.  Remember that this is just the break even figure to cover your costs and desired salary.  There’s no extra profit to market and expand the business.

Questions to ask here are:

• How does an hourly rate of $107 compare with the industry average?  Is it competitive?
• Can you really bill out $535 a day (107 x 5 billable hours) or $2,675 for each 5 day working week?

Try calculating your own figures to see what hourly rate you come up with and decide if the rate is both competitive and feasible.  Will you be able to meet that goal of 25 billable hours each week?  Your business will be running at a loss until you reach that target.

Use a cash flow forecast

A cash flow forecast is a useful way to check your break even calculations.  Completing the forecast will force you to think more carefully about both variable costs and fixed costs.  Get advice if necessary from an accountant because a proportion of some costs such as extra electricity use, may properly belong in variable costs of production rather than fixed costs.

Completing the sales side of the cash flow forecast will also help you identify how long it might take for your venture to break even.

For example, in the manufacturing example above the business needed to sell 1,818 garden benches over the course of the year.  However, demand would likely be very slow in the winter months before picking up again in the spring.  Meanwhile, the business’ running costs still have to be paid every month.

The bottom line figure for each month will show you when the business is likely to break even and how much funding you will need to keep the business going until then.

Make sure you are covering your costs and maximising your profits.  Next week we will focus on reviewing pricing for your products as this is the other key element when it comes to making a profit and ensuring the health of your business.  If you would like help and support reviewing your business’ financial health for the new financial year ahead, call us today on 9204 3733 for an obligation free review.