We all do it. We go to the doctor every year for a physical exam. Most of us do not get a physical exam because we feel poorly. Instead, we do it because we know that sometimes, just below the surface, lurks a problem that has not yet manifested itself. We also know that even a small problem, if left untreated, can become a large problem with dire consequences.
Then why is it that many business owners fail to treat their business health in the same way—getting a “financial physical” once a year, just in case? For business owners, merely running financial statements each month is not sufficient to assess the financial strength of a company. A more in-depth examination of the results of its operations will reveal danger areas for a business or identify particularly strong areas that should be exploited further.
The first step in a financial physical is to perform a “benchmark study”—a financial snapshot of an industry group that allows individual business owners to compare their operations to others of similar size, within the same industry. To complete a benchmark study, a company must compute certain financial ratios. Financial ratios for a business owner are like MRIs for a doctor—they allow a manager to identify and cure the cause of a problem, not just treat the symptoms. The types of ratios most useful for business owners to track include gross profit margin, number of days of inventory on hand, average number of days outstanding for accounts receivable, and debt-to-net-worth ratio.
Space does not allow for a complete tutorial of how to compute and use financial ratios. In practical terms, however, financial ratios help answer questions such as:
- Exactly how much more could I be making if I managed my cost of goods as efficiently as my peers? How does my operating profit compare to others in my industry?
- How do my cash flow and liquidity levels compare to others? Exactly how much more cash would I have in the bank if I could manage my receivables at least as well as the average company in my industry?
- If I’m making a profit, why don’t I have any cash?
- Compared to industry peers, how much excess inventory am I carrying?
Becoming comfortable with and routinely using financial ratios can provide a vast array of benefits to a business manager, including:
- Enabling the business owner to spot changes necessary to correct or avoid future “profit drains.” After all, isn’t it better to fix a small leak early than to wait until the drywall is ruined?
- Since bankers use financial ratios in making loan decisions, a business owner anticipating a future loan request can make the adjustments needed to improve their ratios, thereby increasing the likelihood of loan approval.
- Improving a company’s financial ratios will help maximize the value of a business being sold.
The next step in performing a financial physical of a business is to determine the company’s breakeven point. Costs in a company tend to behave in one of two ways—variable or fixed. Variable costs are those that fluctuate up and down as sales increase or decrease. You might say that sales “cause” these types of costs to occur. Cost of goods sold is an example of a variable cost. Fixed costs are those that are not tied directly to sales. Fixed costs exist regardless of sales volume. Office rent and insurance are two examples of fixed costs. Breakeven is that exact point in a month, quarter or year when the company has covered all of its fixed costs and starts to make a profit on each future sale.
So why should a business manager care about their breakeven point? Because knowing a company’s breakeven point allows a manager to know exactly what will happen to the company’s financial picture if it expects a change in sales volume, costs are projected to increase or decrease, or the company is considering changing prices. Breakeven analysis is a tool that a manager can use to make adjustments today for changes they expect to occur in the future.
Examples of business dilemmas that can be answered using breakeven analysis include:
- Your lease is due to expire three months from now. The landlord just called and said that if you want to stay, rent will increase by $2,000 per month. How much in additional sales will have to be produced to pay for the rent increase without having to increase prices to our customers? Can we afford to stay or should we move?
- The company has just hired a new salesperson. What sales quota should be set so that the company is no worse financially than before hiring the new person?
- Your main supplier just called, notifying you of a price increase of three percent beginning next month. To avoid raising prices to customers, and to avoid losing money, how much in additional sales will be needed to cover the three-percent increase?
- Your company needs a new truck, but you are not sure if the company can afford to make the loan payments out of next year’s projected sales increases. Is now the right time to buy the new truck or should we wait?
- The company is considering raising prices by five percent, but is concerned that by doing so, certain customers will choose not to purchase. What decrease in unit sales can the company absorb before it is worse off than before the price increase?
Breakeven analysis is a very practical decision tool for a manager. The scenarios where it can be useful are almost limitless.
A benchmark study using financial ratios and breakeven analysis are two essential diagnostic and decision-making tools that should be in every manager’s toolbox. Use them at least once a year to ask yourself, “Does it hurt when I do…this?” For the good of your company, get a financial physical today. iBi