Business owners often focus on growth, but long-term success depends just as much on understanding the financial warning signs that can emerge along the way. In a challenging economic climate, keeping a close eye on key financial indicators is just as important.
In our latest blog, Alun Evans, Partner at Bevan Buckland's Haverfordwest office, shares practical advice on how to spot potential issues early by monitoring core financial metrics, helping business owners take action and build resilience for the future.
Great business leaders throughout history have come up with a sound bite to guide others.
To quote John Paul Getty (Founder of Getty Oil), the formula for success is:
“Rule #1 – Rise early,
Rule #2 – Work hard,
Rule #3 -? (see below for answer. Take a guess first!)
Additionally, to quote Warren Buffett (investor, philanthropist, and the chairman and CEO of the conglomerate Berkshire Hathaway):
“Rule #1 – Never lose money
Rule #2 – Never forget Rule 1”
I am sure you can think of many others.
As accountants, we always strive to advise clients on how to be more successful and to weather the storms that will inevitably arise in the business cycle.
Running a business successfully isn’t just about growth; it’s about vigilance. Many companies fail not because of a lack of sales, but because warning signs were ignored. (“Turnover is vanity …”). By monitoring key financial indicators, you can spot trouble early and take corrective action before it’s too late.
Listed below are the main areas to monitor in your business. Please note that these are industry benchmarks. I suggest you use these as benchmarks and compare them to your previous years’ results to see how you are doing.
In my view, the key factors are:
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Gross Profit Percentage (GP%)
GP% shows how much profit you make after deducting the cost of goods sold.
Formula: GP% = Gross profit ÷ sales x100
Example:
Sales = £500,000
Cost of Sales = £300,000
GP% = 200,000 (500,000 – 300,000) ÷ 500,000 × 100 = 40%
This is arguably the most important number in the accounts. If GP% falls from 40% to 30%, you may be experiencing rising costs or pricing pressures. Investigate supplier costs, wastage, or discounting.
An increase in margin nearly always translates into higher net profits on consistent sales. For a business that buys and sells goods, gross profit measures the success of selling bought-in goods at a profit. For professional services firms, the key direct cost is salaries. For farming, it’s variable inputs. Whatever sector you are in, just be consistent and monitor at least quarterly to keep you on the straight and narrow.
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Wages as a Percentage of Sales
This is labour costs compared to revenue.
Formula: Wages % = Wages ÷ sales x 100
Example:
Wages = £167,000
Sales = £500,000
Wages % = 167,,000 ÷ 500,000 × 100 = 33%
If wages rise to 40% without sales growth, profitability suffers. Look at efficiency or staffing levels. With the increase in the living wage and employers’ national insurance, the old 1/3 rule for wages, overheads, and profits rarely applies. As a rule of thumb, if your labour costs (including employers’ NI and pension contributions) exceed 40%, it may be time to make changes.
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Net current assets (NCA)
This measures the liquidity in your business by focusing on short-term assets that can be sold quickly, compared to liabilities that are due in the very near future.
Formula: Current assets – current liabilities
Or more commonly: Current assets ÷ current liabilities
Example:
Stock – £50,000
Debtors = £70,000
Cash = £25,000
Total current assets = £145,000
Suppliers owed £65,000
Tax and VAT owed £40,000
Current liabilities = £105,000
Non-Current Assets (NCA) = £40,000 (£145,000 – £100,000)
The fact that the NCA is positive is a good starting point, but you need to dig deeper and establish the NCA ratio.
In this example its 1.4 (£145,000 ÷ £105,000).
Ideally, a ratio of 2 or higher is considered the standard.
This is a working capital test, or a test of immediate solvency. Generally, a ratio of 2:1 is considered satisfactory. Anything higher could indicate the company is not making the best use of its assets for growth and investment. A ratio below 1 is a warning sign. A negative figure usually demands action, as it indicates cash flow pressure and possible future failure.
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Net Assets
This measures the strength and resilience of your business.
Formula: Total assets – liabilities = your financial strength
Example:
Assets = £600,000
Liabilities = £400,000
Net Assets = 600,000 – 400,000 = £200,000
This is a sign of business wealth. If it increases each year, you are getting richer; if it drops, then you are getting poorer. Successful business owners demand this increase each year.
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Debt Levels
Debt levels show borrowings compared to equity.
Formula: Debt ÷ Equity
Or Debt ÷ Profit after tax
Example:
Debt = £300,000
Equity = £200,000
Profit after tax = £50,000
The most common measurement is the Debt-to-Equity Ratio = 300,000 ÷ 200,000 = 1.5
A ratio above 1 means debt exceeds equity, which is a higher risk. If it rises to 2 or more, consider refinancing or reducing borrowings. However, I advise clients to also consider debt as a multiple of profit after tax, the same as you would when applying for a personal mortgage. In the example above, debt is 6 times profit after tax. That may be fine for a business that invests in property and machinery, but a bit high for a consumables business.
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Return on Equity (ROE)
This measures how effectively you use shareholders’ funds to generate profit.
Formula: ROE = Net Profit ÷ Equity × 100
Example:
Net Profit = £50,000
Equity = £200,000
ROE = 50,000 ÷ 200,000 × 100 = 25%
If ROE drops to 10%, review cost control and asset utilisation.
ROE shows the return on your business assets. If it’s above 10%, it is generally seen as a sign that a business is performing well. If it’s in single figures, you are keeping up with inflation. If it’s negative, you should re-read the first five benchmarks.
Final Thoughts
Early detection is key. These indicators: GP%, wages ratio, NCA, net assets, debt, and ROE are your business’s vital signs. Regular monitoring and proactive management can prevent minor issues from becoming major crises.
Please contact your usual Bevan Buckland contact for more details. If you’re not a client, we’d be happy to chat about these benchmarks or help you set up a regular management reporting system.
Answer to quiz
JP Getty – Rule 3 is “Find oil.”
