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Knowledge Center - Best Practices

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Key Performance Measures

by Darlene Leonard, Smith Leonard PLLC

 

I.   Profitability – measures the amount of money received in exchange for money spent

 

  • Gross Margin = Sales Revenue – Cost of Goods Sold

If this is too low, you need to evaluate your pricing and if there is a better source to purchase your goods or are there costs that you should reduce.

 

  • Profit Ratio = Net Income + Sales Revenue

Same issues as above related to gross margin.  This ratio is computed after all indirect costs, so all expenses of the company should be evaluated for excessiveness.

 

  • Return on Investment or ROImeasures overall profitability

 

    • Return on Assets = Net Income + Total Assets

 

This ratio measures the rate of return on total assets employed in the business and is an indicator of how well the business is managed.

 

If this is too low, your revenues may be too low for the amount of assets employed, or you may not be turning over your inventory enough (wrong merchandise, prices too high, etc.)

 

    • Return on Equity = Net Income + Total Equity

                       This ratio measures the rate of return to the owners of the business

If this is too low and your return on assets is sufficient, you may have too much money invested in the company. 

 

II.   Productivity -  measures the output produced compared with the input expended.

 

  • Personnel Measures – helps you determine if you have too many  (or the wrong) people on the payroll
    • Sales per Employee
    • Gross Margin per Employee
  • Inventory Turnover = Cost of Goods Sold + Average Inventory

 

This ratio is expressed in annual terms and shows how rapidly inventory is moving.

 

If this rate is too low it can indicate that you have too much inventory on hand, the wrong inventory on hand and/or your pricing is too high.

 

III.  Financial Management

 

  • Liquidity – represents the short-term financial strength of the operations.  It is your ability to meet short-term debt obligations from currently available fund
    • Current Ratio = Current Assets + Current Liabilities

This ratio is a rough indicator of whether cash on hand plus the cash flow from collecting receivables and selling inventory will be enough to pay off the liabilities that will come due in the next period.  Businesses are often required to maintain a minimum current ratio of 2.0 or 2-to-1 (for every $1 of current liabilities, they have $2 in current assets).

 

    • Quick (Acid Test) Ratio = (Current Assets – Inventory) + Current Liabilities

 

This ratio eliminates inventory because it cannot be quickly liquidated.

 

The general rule is that the acid-test ratio should be at least 1.0, which means that liquid assets equal current liabilities.  Of course, falling below 1.0 doesn’t mean that the business is on the verge of bankruptcy, but if the ratio falls as low as 0.5, that would be cause for alarm.

 

If your liquidity is too low, you may be in trouble if you business has a slow period.  Liquidity can be increased by obtaining long-term financing.

 

 

  • Leverageis the extent to which a company is financed by debt as opposed to funds from the owner.
    • Assets to Net Worth = Total Assets + Equity
    • Debt to Total Assets = Total Debt + Total Assets
    • Accounts Payable to Inventory  = Inventory + Accounts Payable  

The higher the ratios the higher your leverage.

 

If your leverage is low, then you may have the capacity to borrow additional funds and earn more money if profit ratio exceeds your interest cost.  If your leverage is too high, you could be using too much of your profits to pay interest.

 

 

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