HEATHER WARD explains another valuable series of ratios – financial ratios – that help coffee professionals understand and develop best practices to keep their roaster/retailer business healthy and financially sustainable in Issue 6 of 25 Magazine.
SCA’s 2017 Roaster/Retailer Financial Benchmarking Report includes a series of financial ratios that reflect leading best practices and performance of coffee retailers and roasters in specialty coffee.
It contains valuable data – key operating data, sales mix data, and business profile information presented as industry aggregates – which industry members can use to compare their own business’s performance with others’. With a fuller understanding of the report’s key components and, more importantly, an understanding of how to use the information, it can be used as a tool and guide for those who seek to learn about financial management of business, improve their own financial performance, and better understand the financial landscape of the community.
Understanding the Metrics
The report contains key financial ratios – “performance measures” – used to compare a business’s performance to reported norms in each of three areas: profitability, productivity, and financial management. You should always start any examination of the health of your business with these performance measures: as discrepancies are identified between your business’s performance measures and the reported norms, you’ll know where you need to focus your time and energy.
There are several ways to look at profitability and the most frequently cited is net operating profit (NOP), or net profit as a percentage of sales/total revenue.
This ratio measures the difference between a business’s total sales and what it spends over a period of time: it is highly dependent upon a business’s pricing policy and expense control. If gross margin (net sales minus cost of goods sold) increases, or expenses decrease as a percentage of revenues, NOP will rise.
NOP is a good overall measure of how well gross margin and expenses are being controlled, but perhaps the best measure of overall profitability is return on investment (ROI). The two most important measures of ROI are return on assets (ROA) and return on net worth (RONW).
ROA is an excellent indicator of the percentage return on total assets employed in the business. As is the case with NOP, using profit before tax is a good idea. In addition, profit before taxes and interest divided by total assets is an even more “pure” look at the operational efficiency of the business, because the amount of interest paid depends on the amount of debt the business needs or wishes to incur. This is a matter of financial policy and is not directly related to the operational efficiency of the business.
While ROA measures ROI from a business management standpoint, RONW is the best measure of return to the owners of the business. It is defined as profit before or after tax divided by net worth. RONW is the percentage return to the owners compared to the amount that they have invested in the business.
Productivity is simply the output produced compared with input expended. As a rule, the more output produced per labor hour, employee, dollar investment, or whatever the input, the more profitable a business can be. Companies need to always strive to improve the productivity of their principal assets: inventory and personnel. However, to improve productivity, you first have to measure it. Inventory productivity is best measured by inventory turnover, defined as the cost of goods sold divided by average inventory.
This ratio shows how rapidly inventory is moving and is expressed as “annual turns.” Personnel productivity can be measured in numerous ways. The easiest and most commonly used methods are:
Total revenues per employee: a good overall measure, but subject to distortion by inflation. Always use full-time equivalents for employee counts.
Gross margin per employee: complements the previous measure by subtracting cost of goods sold. It is less distorted by inflation.
Asset turnover (net sales divided by total assets): presents a good overall indicator of total business productivity. The ratio tells us how many sales dollars are being generated by each dollar of assets employed in running a business.
There are two financial management issues that should be of primary importance to all precast businesses: liquidity and leverage. Liquidity represents the short-term financial strength of the business. It is your ability to meet short-term obligations out of currently available funds. Two liquidity measures are commonly used:
Current ratio (current assets divided by current liabilities): measures the extent to which fairly liquid assets (all current assets) exceeds current debt.
Quick (acid-test) ratio (current assets less inventory divided by current liabilities): eliminates inventory from the numerator because it is not extremely liquid, and compares the result to current debt. Therefore, the quick ratio is often considerably lower than the current ratio.
Leverage is merely the extent to which a business is financed by debt as opposed to the owners’ funds. It is the amount of liabilities in relation to the amount of net worth on the right-hand side of the balance sheet. The most significant ratio of overall business leverage is total assets to net worth. The higher this ratio is, the higher the leverage. Debt to equity (total liabilities divided by net worth) is another common measure of business leverage used within this report.
Using the Report
Once you understand the components of the report and have identified your performance measures, you’re ready to compare your business’s metrics to the benchmarks in the SCA report. However, it is important to remember a few things:
- A deviation between your business’s figures (for any performance measure) and numbers in the report is not necessarily good or bad. It merely indicates that additional analysis may be required. As a rule, the larger the difference, the greater the need for further investigation.
- In situations where large deviations do exist, it may be helpful to go back and calculate the same performance measure over the past several years to identify any trends that may exist.
- The information should be used as a tool for informed decision-making rather than absolute standards. Since businesses differ as to their product emphasis, location, size, and other factors, any two businesses can be successful yet have very different experiences with regard to certain performance measures.
It is important to remember that while the key performance measures are excellent “yardsticks” for gauging the success of your business, they must be understood, not just applied blindly. For instance, if the profitability of your facility is far below the reported benchmark, it is important to know why. Is your business really suffering or is your profitability artificially low because you are paying high salaries?
HEATHER WARD is SCA’s Senior Manager for Content Strategy. She was the lead researcher on the 2017 Roaster/Retailer Benchmarking Study.
About the 2017 Roaster/Retailer Financial Benchmarking Report:
The 2017 Roaster/Retailer Financial Benchmarking Report transpired when a group of coffee roasters in the specialty community sought shared business information. They were looking for leading business practices and key performance indicators that would help them with writing business plans and setting sales targets. Rather than working off gut feelings or assumptions to support their business decisions, the business owners and managers craved data and evidence of what the industry was doing.
The report is based on the results of a survey that was sent out globally in May 2017 to roaster wholesalers, roaster retailers, and coffee retailers (non-roasters). The survey and results were hosted on an online platform that was created and managed by Dynamic Benchmarking, LLC.
For more information on and/or access to SCA’s 2017 Roaster/Retailer Financial Benchmarking Report, please visit sca.coffee/availableresearch.
How Does Your Business Compare?
Once you’ve calculated your metrics as described here, you’re ready to compare your business’s metrics to the benchmarks in the SCA report.
Is your number significantly higher or lower than your benchmark in the report? Use these guides to learn more. Keep in mind: these are only guidelines for action and should not be considered specific recommendations.
Net Operating Profit
Too High: It is difficult to imagine a situation where this presents a problem, but you should know why the net profit margin is so high.
Too Low: Further investigation is warranted. Check to see if cost of sales is too high. If so, check costs by product type. Check all expense categories to see which need better control.
Return On Assets
Too High: No problem as a rule. You are effectively managing your business.
Too Low: Either Revenues or net profit before taxes is too low to support your asset structure. Examination of net profit before taxes value and asset turnover will tell which.
Return on Net Worth
Too High: This is a very good situation unless the degree of leverage is too high.
Too Low: If return on assets is sufficient, you may have more of your funds invested in the business than necessary. (See Leverage.)
Too High: No problem as a rule. May be artificially high if many functions are performed by outsiders not on the payroll.
Too Low: Low personnel productivity during normal business conditions may indicate the business is too “people heavy.” Consider decreasing staff size or generating more volume from existing personnel.
Too High: Excessively high inventory productivity generally means too little inventory is available and may result in shortages.
Too Low: This could indicate either a lack of volume or an overstocked condition. Investigate by product type.
Average Collection Period
Too High: May mean a poorly organised and managed receivables management system.
Too Low: Usually is preferred, unless credit policies are too restrictive and thus, result in lost sales.
Total Asset Productivity
Too High: Asset Turnover, which is significantly in excess of the reported norm, might be caused by the absence of owned fixed assets or the lack of any significant amount of receivables. Check your percentage balance sheet with the composite for your sales volume category.
Too Low: Low asset turnover can signal a need for more attention to the productivity of the areas previously described.
Too High: If liquidity is exceptionally high, it is possibly a sign of excess inventories and receivables. Check productivity ratios for these items. Otherwise, there is no reason for concern.
Too Low: If current and quick ratios are too low, it is possible you are operating with insufficient liquid capital. This can be dangerous if business takes a turn for the worse or a loan payment becomes due unexpectedly. Liquidity can be increased by using more long-term financing and/or by leaving more profits in the business.
Too High: This will severely curtail your ability to attract new borrowed funds. In addition, interest charges could be strongly affecting profitability. Try to retain more profits in the business or attract new sources of equity if you wish to lower leverage.
Too Low: You have excess capacity for debt should it become necessary to borrow. Although some owners do not like borrowing any more than absolutely necessary, additional debt will increase overall profitability as long as the business can earn a before tax return which exceeds the borrowing rate.
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