Monitoring Business Performance – Part 3
How effectively do you monitor your business’ performance?
There are many performance measurement tools available off the shelf, but have you thought about creating your own? It’s not as difficult as you might think…
In my previous blogs I looked at how a simple one-page KPI Dashboard focused on profitability and liquidity can benefit a cash-based business.
Also, how this can be expanded to include assessment of the key components of working capital as a business grows and begins to offer and receive credit.
These blogs focus on operational performance and the measures discussed are actions the owners and managers of businesses (i.e. internal stakeholders) need to be on top of.
But what about external stakeholders – people outside the business, such as bankers and other providers of credit?
Their interest generally focuses around leveraging (i.e. your business’ ability to repay these external stakeholders).
The following ratios provide a warning measure of your business’ ability to reduce long-term debt (for measures of short term cash management take a look at my blog on working capital at Monitoring Business Performance – Part-2).
The Leveraging Ratios I find particularly useful are:
a) Debt Ratio measures how exposed your business is to its bank and other financiers. Generally speaking a ratio below 0.5 indicates (i) that your business has a lower capacity to borrow additional funds or may be over-geared; and (ii) that your business could be in danger if its financiers call upon borrowings.
For example, if your business has $1,000,000 of liabilities but only $4,000,000 of assets its Debt Ratio is 0.25 – well below the generally accepted 0.5.
b) Debt to Equity Ratio measures the proportion of shareholders’ equity to debt. It’s essentially a more stringent risk assessment than the Debt Ratio above. When calculating this ratio, pay careful consideration to (i) equity securities which have both debt and equity properties, such as preference shares; and (ii) consider whether you would prefer to use book or market values for the various components of the formula.
c) Debt Coverage Ratio measures a business’ ability to produce enough cash to cover its principal debt repayments. Generally speaking the higher the ratio the greater the capacity to borrow additional funds.
As this ratio only measures the ability to cover principal debt repayments, it should be reviewed in conjunction with the Interest Coverage Ratio, which is calculated as:
In summary, we began by looking at how to measure the performance of a simple cash-based business (Monitoring Business Performance – Part-1), expanded this to capture working capital management as the business grew and began accepting and offering credit terms (Monitoring Business Performance – Part-2) and have finished by looking at the performance measures banks and other financiers use.
It’s important to note that although KPI results on one business are helpful when viewed as a trend, they provide a much greater benefit when compared against industry benchmarks.
Sourcing benchmarks for working capital and leverage comparison may not be as easy as obtaining some of the simpler KPIs used by a cash business, but try ATO – Small Business Benchmarks or Ibis World. Don’t be afraid to use a common sense approach in interpreting and applying the economic and political commentary we are exposed to every day in the media.
Remember, if you find your business isn’t achieving the results you had hoped through growth from a simple cash-based operation, it might be worth considering the reasons why – and whether you should downsize or revert to some of your previous successful practices.
Elizabeth Mawby was a former Client Director at Vantage Performance, Australia’s leading business transformation and turnaround firm – solving complex problems for businesses experiencing major change.