​Understanding Metrics of a Good Business

Business metrics are used to evaluate performance of a business within a specific period and on a specific aspect of operations. Most often, these metrics involve quantifiable units such as number of products sold, cost of operation, overhead cost, direct labor, indirect expenses and among others. These tools help management to formulate decisions regarding operations, whether to hire more, sell more or cut back costs.

Depending on the level of decisions needed, understanding business metrics is easy on some areas and rather complicated on others. Metrics are not stand-alone tools to create the right decision for your business. You also need to consider non-quantifiable factors that affect your operations to derive the most equitable solutions and decisions for the company.

So, what are these metrics and how can they be of help to you and to the growth of your business?

Financial Statements

Indeed, financial statements are the most common metrics that you can use to see if your business is performing well. However, they alone are not enough to create sound decisions. Other financial analysts argue that financial statements are not indicative of the business' real performance. Why? Because you can, or your accountant can window dress the outcome of your financial statements. There are three major financial statements relevant to your business either for internal or external purposes: income statement (or statement of operations), balance sheet (or statement of financial position) and the cash flow statement.

Statement of Operations

Your income statement shows your profit and how much your cost is to generate desired profit level. Positive bottom line (income) is good and negative bottom line (loss) means problem within the business. It is as simple as that. However, you may show a high profit but it does not mean that your business really created the income.

On the other hand, negative income in two consecutive months does not mean that your business is gearing towards bankruptcy. There are factors that may have contributed to the negative or positive figure. These factors should be evaluated for you to conclude that your income is what you really have earned for the period.

Factors That Affect The income Statement

As mentioned, it reflects your sales for the period and the expenses related to the generation of income. There are two tiers of expenses in the income statement, which affect the net income.

First tier refers to the cost of sales, or cost of services that directly affects the gross sales. Take for example, buy and sell of fashion clothing and accessories. The cost of sales would be your purchases of dresses, accessories, and shoes. Without the purchase, your sales would not be completed.

Second tier refers to the overhead costs which are necessary for the operations of your buy and sell. They may include salaries and wages, commissions, utilities, communication, cost for running the web site if you are into online, and so on. In this tier, expenses are the combination of cash and accrued expenses.

Cash expenses are sometimes called the real expenses since transactions usually involve cash out in the same month that the expense is incurred. Examples of cash expenses are salaries and wages, commissions, utilities and communication expense.

On the other hand, accrued expenses may or may not have been used or are just provisions for the period. Classic examples are depreciation expense, allowance for doubtful accounts, and prepayments.

Financial Metrics Related to Income Statement

Gross Profit Ratio/Margin (formula= Gross Profit/Net Sales). This ratio is a useful tool to ascertain how much profit is generated for every dollar of sales. The higher the profit margin is the better. If you have 25% gross profit margin, it means you have 25% of the total net sales to cover other expenses essential in the business. Another way of interpretation is you can lower your prices by 25% without incurring any losses. However, before lowering prices you needed to consider other expenses.

Net Income Ratio (formula= Net Income before Taxes/ Net Sales). This ratio is slightly different from the profit ratio. The percentage derived from the formula is used to evaluate the efficiency of the business to control cost. The higher your ratio compared to other business in your industry means you have better control of your expenses. Generally, that is the case. However, there are instances that you may have lower ratio but still business efficiency is higher than with competitors. One is comparing real and accrued expenses. You may have lower real expenses and higher accrued expenses, while your competitors have higher cash outlay in expenses but lower accrued expenses.

Balance Sheet (Statement of Financial Position)

This financial statement reflects your assets, liabilities and capital (or equity invested). Assets portion shows the properties a business owns while liabilities portion shows what the business owes to outsiders like creditors, bank or other companies. Equity is the portion that reflects the investor's claim over the business. It is related to the percentage of ownerships. Thus, a business can be owned by more than one individual, if the organization is either partnership or corporation.

Financial metrics in balance sheet

Working Capital (Formula= Assets - Liabilities). The working capital is the cash or assets available to keep the operations going. The lower the working capital the harder it is for the business to continue operation. However, negative working capital does not mean that the business cannot continue anymore. It is just an indication that managing of cash outlay is inefficient and that control or it is time cut back costs.