The purpose of benchmarking your financial performance is to find opportunities to improve your profitability and cash flow. The process of benchmarking is to compare your results on certain key performance measures against your past results and/or the results of other companies like yours so you can identify opportunities for improvement.
The big question is which metrics should you benchmark. Which metrics really matter and which ones, if you are successful in improving them, will make a meaningful impact on your quest to improve your profitability and cash flow.
Because I am a big fan of simplification, and sometimes getting started is half the battle when trying something new, I have three metrics that I believe really matter. Not twenty… just three. They are:
- Gross Margin
- DSO (Days Sales Outstanding)
- Capital Expenditures
Let’s look at each one.
Gross profit is revenues minus cost of goods sold. Gross margin is gross profit divided by revenues. This is one of the most important measures of the strength of your business model. If your prices are too low, or your cost of goods sold is too high, your gross margin will suffer. It is almost impossible to succeed in business without a healthy gross margin.
Here are some important questions that benchmarking can help you answer:
- Have your gross margins gone up or gone down over the last three years?
- Have your gross margins gone up or gone down over the last six to twelve months?
- What kind of gross margins do your competitors generate?
- What kind of gross margins do businesses that are similar to you (but not necessarily your competitors) generate?
- When was the last time you raised your prices?
DSO (Days Sales Outstanding)
DSO is the average number of days of sales that are sitting (and sometimes stuck) in accounts receivable. It’s a great measure of how well your company is collecting receivables (given the terms you extend to customers).
Making the sale to a customer is a win… not collecting on the sale is a ticket to the poor house. I have seen many times in my career where a consistent focus on DSO by the management team helped drive accounts receivable down and freed up much needed cash for the business. DSO is an important high level tool for monitoring the speed with which you turn your sales into cash.
Here are some important questions to answer about your DSO:
- Do you track your DSO each month?
- Has your DSO gone up or gone down over the last three years?
- Has your DSO gone up or gone down over the last six months?
- What are the DSO levels for companies similar to yours?
- Do you have a person who is responsible for collecting your accounts receivable?
Capital expenditures are the purchases you make for longer term assets to sustain your existing business as well as to invest in new assets to create future growth. Capital expenditures are poorly managed in many companies. The problem starts with the fact that you don’t see capital expenditures (the purchase of a vehicle, equipment, buildings, etc.) in your income statement when the expenditure is made. The expenditure is recorded on the balance sheet. Then the cost of the asset you purchased (and capitalized) is depreciated over the life of the asset.
As a result, it is very easy for cash to “leak out” of the company with no one really knowing. In one small company, management was so focused on the income statement and keeping expenses down that they let over $100,000 of cash virtually disappear in the form of capital expenditures without realizing it. They were a smart management team. They were financially oriented in many ways. But they still let over $100,000 of cash walk out the door. They didn’t even realize what had happened until I pointed it out!
Here are some important questions to answer about your capital expenditures:
- Do you have a one-page, written capital expenditures plan for the year?
- Have your capital expenditures gone up or gone down over the last three years?
- How much of your capital expenditures are for growth as opposed to maintaining existing assets?
- What kind of capital expenditures do businesses that are similar to you spend annually?
- Do you pay close attention to capital expenditures every month?
In order to survive and thrive in business, you have to consistently work on improving your profitability and cash flow. The competitive landscape is changing too fast to let us get by with the status quo. Either we work on improving all the time, or we risk falling further and further behind.
Both internal benchmarking and external benchmarking can be powerful tools for helping you improve your profitability and cash flow. It will help you hone in on the metrics that matter in your business.