Getting your head around the complexities of accounting can be tough, but it can be massively rewarding to know a few key accounting measures that you can use to give you a quick overview of how healthy your business is. That's why we’ve worked with our partners Evenstone to put together the 3 most important accounting measures which you can use to better understand the health of your business:
1. Gross margin.
To run a profitable business, it is fundamental that you understand your gross margin. The gross margin is the sale price of a product less the direct cost of getting that product to the point of sale.
For example, a company is selling widgets at a price of £100. They buy the widgets from a supplier at a cost of £40 per unit, and are charged £5 per unit to package the widgets. It costs £3 per widget in shipping to arrive at the warehouse. The gross margin is therefore £52.
Understanding the £52 is important as you can now work out how many units you need to sell to cover all the overheads in your business. For example, the company has costs of £52,000 a year in rent, utilities and fixed salaries. The business owner now knows that they have to sell 1,000 widgets to cover all these costs.
The business owner now also knows that any sales over the 1,000 units are generating a profit of £52 each and so can start making decisions about what to do with that profit - additional advertising, product development etc.
Conversely, if they know the level of sales isn’t sufficient to cover the fixed costs, they can also start working out what they need to do to rectify the situation. How much does the sale price need to go up by? Could any of the costs come down? How would those changes affect the gross margin and therefore the overall profit?
Most businesses don’t sell a single product and so the calculations of gross margin are more complicated. Accounting reports with up to date data are therefore crucial to understand what is going on across the business.
The best way to monitor this is by looking at the business’s profit and loss reports - either for individual months, or for a year at a time. Look at the ‘gross profit’ or ‘gross margin’ line to see what gross margin you are getting, and then look at the ‘net profit’ or ‘net margin’ line to see whether the gross margin is covering all the fixed costs.
2. Profit margin.
Profit margin is a useful measure which tells you for every additional sale you make, how much profit you will generate. It is calculated by taking your net profit after tax and dividing it by your sales.
For example, a company makes a net profit after tax of £25,000 on sales of £100,000. Their profit margin is therefore 25%.
Knowing that they have a profit margin of 25%, the business owner can now quickly estimate levels of profit on future sales.
For example, the company generates an additional £50,000 of sales. The business owner knows that that equates to roughly £12,500 profit.
This is useful as a ready reckoner to make decisions about future plans rather than waiting for end of year accounts to be produced. It is also useful to monitor it over time to make sure that profit margins are being sustained or improved and aren’t dropping.
3. Working capital.
A lot of business owners don’t often look at the balance sheet, seeing it as the domain of accountants, and whilst it is true that it is here that you often find the more specialist accounting terms being used, it is a very useful measure of the health of your business. Working capital is the difference between current assets and current liabilities and tells you how likely you are to be able to meet short term bills.
For example, a company has stock of £25,000, trade debtors of £10,000, and a bank balance of £5,000 so its current assets are £40,000 in total.
It has trade creditors of £30,000 and a tax liability of £5,000 so its current liabilities are £35,000.
Its working capital is therefore £5,000 – it has £5,000 more in assets than it does in liabilities.
It is important to get the balance right with working capital. You need enough to be able to pay your suppliers and the tax man as bills become due, and it is useful to have an excess to be able to take advantage of any opportunities that come up. This needs to be balanced though, with having large cash reserves that could be better invested in growing and developing the business.
Most accounting software will show you your working capital on the balance sheet report as a specific line item. It may be labelled ‘current assets less current liabilities’ or ‘net current assets’.
Now that you have a grasp of the key accounting measures you will be able to better monitor the health of your business. What measures do you use to monitor the health of your business? Comment below.