Using key indicators to see how well you’re doing

It is fairly easy, when you’ve seen an opportunity, to set up a business to exploit it, and to do quite well for a couple of years. Difficulties often come when continuing beyond that or when trying to expand.

Sometimes the reason is that the opportunity was one that was only ever going to be short-lived. More frequently, however, business owners move from day to day without a long-term plan, or, if they have a plan, without any way of measuring their progress against it.

In this situation the problem lies in knowing how to measure progress – instinct and gut feeling are notoriously faulty. Yet, whatever your business, it is not only possible, but quite easy, to assess the health of your business by using a simple set of measurements called key indicators.

What are key indicators?

Key indicators are a handful of figures that allow you to measure your progress by quantifying the essential elements of your business. They fall into two categories:

1. Key operating indicators, which demonstrate how well the different aspects of your business are working. 
2. Key strategic indicators, which demonstrate how well you are progressing towards your goals.

Both these can be split further into tangibles, such as sales and growth rate, and intangibles, such as customer satisfaction.

Key objectives can either be ratios (for example, stock/turnover); percentages (growth in sales over last quarter); rankings (market position); or absolute figures (number of customer complaints).

The three steps to monitor your business’s health

1. Identify what you want to measure from your business plan. Look at your business plan and extract from it a verbal statement of your aims. Known as a ‘strategic objective’ statement, it will say something like this: ‘Within the next five years, Bloggs Widgets will become one of the top three widget manufacturers in the UK, with a high level of customer and staff satisfaction. Turnover will rise to £2.5million, with a gross margin of 30%’. (If you don’t have a full business plan, preparing such a strategic objective statement is the one of the best ways to start the process.) 
2. Divide the objectives into tangibles and intangibles. In terms of the strategic objectives statement above, the elements of staff and customer satisfaction are intangibles, while market position, turnover and gross margin are tangibles. These can now become your key indicators along with a number of standard ratios. 
3. Work out how to measure your key indicators and create a system for doing this at regular intervals – ideally at least once a quarter. For the tangibles, this is merely an extension of doing your accounts and can even be done automatically by using some standard ratios. For the intangibles, you will need to devise a system of quantifying them.

Measuring tangibles

Some of the things you might want to measure include:

1. Sales. 
2. Number of outlets. 
3. Group and outlet turnover and profits. 
4. Profit/square metre for each outlet. 
5. Profit per employee. 
6. Number of referrals and percentage converted. 
7. Percentage of repeat buys. 
8. Number of employees and employee turnover. 
9. Growth rate. 
10. Website activity and resulting sales.

Some tangibles, such as turnover or total sales, are easy to measure: you just identify a figure in your accounts. Others, such as profit per outlet, or even profit per square metre per outlet, are also easy enough to find once you’ve set up a system that allocates income and expenditure into cost and profit elements.

For others, you need to work out some simple ratios. Such ratios fall into three basic types:

1. Liquidity ratios, which measure your ability to meet your expenses. 
2. Profitability ratios, which measure how well you are doing. They also help you to plan change by highlighting the need for higher sales, bigger margins or lower costs. 
3. Efficiency ratios, which help you assess your stock levels, asset management, use of borrowing and all the other aspects of how you actually manage your business.

If you produce your accounts in an accounting package, most of these figures will be produced automatically. In other cases, you will use the figures in your profit & loss account, balance sheet and other reports as the basis for financial calculations.

Note that some of the ratios in themselves can mean little. Their true value often lies in comparing them over time and identifying trends. Another huge benefit is benchmarking, where you compare your key ratios with those of similar businesses. Healthy ratios for your type and size of business are developed from industry averages. You can then see where you are weak and need to focus, or strong and can exploit it.

Liquidity ratios

The main liquidity ratio is called the quick ratio or acid test. This shows the business’s ability to meet its current liabilities with the money it has readily available. You should exclude stock from the calculation because this is notoriously hard to sell quickly and to do so, you may have to drop the price considerably.

• Quick ratio = (current assets – stock) ÷ current liabilities

So, if your current assets on your books are £13,000, your stock is worth £3,000 and your current liabilities are £5,000, you have a ratio of 2:1. If the ratio were the other way round, at 1:2, you could be in trouble if all your creditors demanded payment instantly.

Profitability ratios

Return on equity (sometimes called return on capital employed) is the profit you made in the year, expressed as a percentage of the capital invested in the business. This is generally considered to be one of the best ways to test your profitability and answers the simple question: ‘Am I actually making more from my capital than I would by investing it on the stock market?’

• Return on equity = net profit before tax ÷ net worth* x 100
  (*on your balance sheet, the difference between your assets and liabilities)

For example, for a company with net profits of £52,000 and a net worth of £129,000, the return on investment would be 40.3%. This is an excellent return compared with the same capital invested in the stock market, which might yield around 8%.

There are two other important profitability ratios that you want to watch – gross profit margin and net profit margin. (Most accounting packages will automatically produce these figures for you.) These should remain reasonably constant or, ideally, improve as you become more efficient and drive down costs. You should investigate carefully sudden leaps either way.

The gross profit margin shows the average profitability of your sales. It shows how much profit is left from each sale after taking off the direct costs of production – such as stock used. The average figure will vary from industry to industry.

• Gross profit margin = gross profit* ÷ sales x 100
  (*Gross profit = sales – cost of sales)

For example, for a company with a gross profit of £92,000 and sales of £138,000, the gross margin would be 67%.

The net profit margin shows how well you are doing as a business overall, taking into account the level of overheads against sales.

• Net profit margin = net profit (before tax)* ÷ sales x 100
  (*Net profit = sales – total expenses)

For example, for a company with a net profit of £52,000 and sales of £138,000, the net margin would be 38%.

Again, the average figure will vary from industry to industry. Many people would like a very high figure for this, but most businesses earn a net profit margin of under 10% and are quite successful.

Efficiency ratios

There are several useful efficiency ratios, some of which are explained below.

Income and expense ratios allow you to check trends easily. (Most accounting packages will automatically produce these figures for you as a percentage of sales or turnover.)

• Salaries ratio = salaries ÷ sales x 100

For example, say your salaries were 22% of your turnover this year, and 14% last year. You may have hired extra staff who are having little real effect on your growth, in which case, you would want to know why.

Equally, if your widget sales accounted for 76% of your turnover last year and only 62% this year, you would want to know why.

Return on sales

• Return on Sales = gross profit per product or service ÷ sales x 100

For example, a company sells £85,600-worth of widgets which cost £32,400 to produce, so its gross profit on widgets is £53,200. The total sales are £138,000. The return on sales for widgets would be 39%.

You may find that some products or ranges produce much better returns than others, so perhaps should be pushed harder. Or it may emerge that overall profitability depends upon more than producing and selling widgets – high customer satisfaction may, in fact, be rooted in the quality of the widget servicing you give, and the amount customers are spending with you on servicing won’t show up in the widget sales figures but in your servicing sales figures.

Stock turnover ratio is important efficiency ratio. It shows how quickly you move your stock on average. Put another way, it calculates how many days on average you hold stock.

• Stock turnover = stock value ÷ sales
• Days on hand = 365 days stock ÷ turnover

Say your stock is worth £50,000 and you have annual sales of £200,000 – you get a turnover figure of 4 times a year. If you do the next stage of the calculation, you have a days-on-hand figure of 91 days. Dependent on the industry you are in, a stock turnover ratio of 4 might be low (compared with the generally accepted desirable ratio of between 6 and 7) and may indicate too many obsolete items in stock, overstocking of certain items, or an unrealistic determination never to be out of any item of stock. This means you are tying up too much vital working capital that could be better used for, say, marketing.

Like other ratios, stock turnover is most valuable when considered on separate product lines rather than on your total stock. One big American supplier of car parts clung to their slogan of ‘We are never out of stock’, which they interpreted to mean ‘You can walk into any of our stores anywhere in the country and get any part straight off the shelf’. This meant that they had a nationwide stock inventory which included several hundred large items such as replacement engines and gearboxes, when they never sold more than a couple of dozen a year. When they realised this, they changed their slogan to ‘Never more than 24 hours wait’, kept the local stores stocked with rapidly moving items, and kept the big items in a few special stores close to ‘hub’ airports where they could be sent to customers within a few hours.

Average collection period

The average collection period ratio works in much the same way, in that you are looking to see how many days it takes for debts to be paid on average.

• Average collection period = total debtors x 365 ÷ sales

If your stated credit period is 30 days, a figure of between 40 and 45 is generally considered acceptable. Anything higher either means you might have problem debtors or a poor collection system. Anything lower means your collection system is excellent – or maybe that you are offering too high a discount for rapid payment!

Quantifying intangibles

Not all indicators can be neatly calculated, particularly intangibles. However, that does not mean they are less important to monitor.

What counts as an intangible? This varies from business to business, and includes such things as customer and staff satisfaction, professional standards, being at the leading edge of your industry, operating in a systematic way, and some other factors such as goodwill. You can’t measure these things, but you can quantify them in the same way sports judges quantify a gymnastic performance – by awarding marks on a scale of 0 to 10.

In competitive sports, 10 is the best possible performance, 0 is the worst (in sports terms, it means no performance at all). In a business context, however, it is sometimes possible to have a performance that is worse than nothing (a branch not only doesn’t make a profit, it actually costs you money to keep it open) so you might want to operate on a scale of -10 to +10.

Take ‘staff satisfaction’, for example. If your staff never went sick, were always reluctant to take holidays, did more than their official hours and never asked for overtime pay, and were always smiling, you might be able to award your business a figure of +10. If they were frequently off sick for minor ailments, consistently late and looked permanently miserable, you might award a figure of -10. Probably your actual figure will be somewhere in between, and your target may not realistically be +10. But you would still need to track your progress towards that ideal situation. So just like the tangibles, you need to make your assessments at least quarterly.

You simply write down the best and worst scenarios at either end of the scale, and make an honest judgement. Ideally, get an independent assessment of some measures, either from those affected or from an outside observer, rather than trying to judge them yourself. Hence, run a quarterly customer satisfaction survey or call in a quality consultant.

Create a tracking system

For both tangibles and intangibles, the easiest way to track your progress is to set up a spreadsheet as follows:

The map is not the territory

Maps are wonderful things and, to the person who knows what they signify, they are full of information – but they are not the same as crossing the country on the ground. A set of contour lines shows a gentle slope but not that the slope consists of slippery rock with intermittent holes full of rattlesnakes. And it’s just the same in business. Business plans and key indicators are not the whole reality.

In the context of working out how your business is doing, this means you need to look at your key indicators regularly, and you need to understand that where intangibles are concerned, putting a performance figure on them doesn’t necessarily make them tangible. It has just given you a way to assess them that is more meaningful than gut feeling.