There are two types of tracking, nice to know and need to know, otherwise known as vanity metrics and clarity metrics. Many industries call them Key Performance Indicators. I’m taking it one step further and say it’s the trend that counts, not the “raw number.”
Often I get asked, “If I were going to track only one or two things, what should they be?” My clarity metrics are current ratio, acid test, productivity ratio, and net profit per hour. The other indicators that many of us track (including me) are nice to know but are not critical to the profitability of your business.
Here’s why: managing labor and materials (if you have them) are critical for profitability. A poorly managed labor force leads to inefficiencies, usually a stressed owner, and lower profitability. Inventory is a bet. If you don’t manage it well, you will be spending your hard earned cash on things you may never sell.
The productivity ratio answers the question, for every dollar of revenue, how much are you spending on payroll and payroll taxes? Divide total payroll including field, office, and owner’s salaries, by sales. This number should be less than 40%. For most months, it should be stable or decreasing. In a slow revenue month, it probably will increase. As revenues increase, this ratio should decrease.
Current ratio and acid test. These two ratios answer the question, can you pay your bills and are you building too much inventory? The trends should be upward. For businesses that don’t have inventory, your acid test equals your current ratio.
Current ratio is defined as current assets (things that are cash or turned into cash within a year) divided by current liabilities (bills you have to pay within a year).
Increasing current ratio and acid test usually means increasing profitability, unless you sold an asset for cash. Decreasing current ratio generally means decreasing profitability, unless you bought an asset for cash or had a huge cash expense, such as your tax bill.
For those of you with businesses that don’t have inventory, your acid test equals your current ratio. Acid test is defined as current assets minus inventory divided by current liabilities. If the spread between current ratio and acid test is increasing, you are building inventory.
Here’s why just the ratio, and not its trend, is dangerous. Let’s assume the industry average for current ratio for your type of business is about 2. Let’s say your company’s current ratio in January was 3. You don’t worry about it because it is above the industry average. However, in February it is 2.8 and March is 2.6. You are still not worried because you are still above the industry average. You should be worried. The trend is downward and it is telling you that you are becoming less profitable. You need to find out why and stop the bleeding!
If your current ratio is 2, your acid test should be 1 or higher. This means that you probably have the correct amount of inventory.
For those of you with materials, if you see that your current ratio is increasing and your acid test is staying constant, this indicates that you are building inventory. Find out why is this happening. If you just got a spring or fall stocking order, that explains the build up. You should see the spread between current ratio and acid test decrease as you use the inventory. If a stocking order is not the reason, find out why you are buying more.
The last clarity metric for me is net profit per hour. This metric answers the question, “For every billable (revenue producing) hour, how many dollars of profit are you generating?” It’s not a percentage. It is a dollar amount.
Calculate it every month. Divide net profit by the number of billable hours. If your net profit per hour is less than $10, you could get a job at a fast food restaurant and earn more than you are earning in your business. If it is negative, you are paying your customers to perform their work.
Only you can determine what net profit per hour you want to earn. Decide what you want, build your pricing around it, and then track it to make sure your company is earning it!
There are other metrics that you can track. However, none are as important to your company’s profitability than productivity ratio, current ratio, acid test, and net profit per hour.