Vanity Metrics vs. Clarity Metrics
Originally published: 01.01.18 by Ruth King
There are two types of tracking: nice to know and need to know, otherwise known as vanity metrics and clarity metrics. Our industry also calls them key performance indicators (KPIs). I’ll take it one step further and say it’s the trend that counts, not the “raw number.”
I often get asked, “if I were going to track only one or two things, what should they be?”
My clarity metrics are: current ratio, acid test, productivity ratio and net profit per hour. The other indicators that many of us track (including me) are nice to know but aren&rsquot critical to the profitability of your business. Here’s why: managing labor and materials are critical for profitability. A poorly managed labor force leads to inefficiencies, usually a stressed owner and lower profitability. Inventory is a bet. If you don’t manage it well, you’ll spend your hard earned cash on things you may never sell.
The productivity ratio answers the question: for every dollar of revenue, how much are you spending on payroll and payroll taxes? Divide total payroll — including field, office and owner’s salaries — by sales. This number should be less than 40 percent. For most months, it should be stable or decreasing. In a slow revenue month, it probably will increase. As revenues increase, this ratio should decrease.
Current Ratio and Acid Test
These two ratios answer the question: can you pay your bills and are you building too much inventory? The trends should be upward. Increasing current ratio and acid test usually means increasing profitability, unless you sold an asset for cash.
Decreasing current ratio generally means decreasing profitability, unless you bought an asset for cash or had a huge cash expense, such as your tax bill.
Current ratio is defined as current assets (things that are cash or turned into cash within a year) divided by current liabilities (bills you have to pay within a year).
Acid test is defined as current assets minus inventory divided by current liabilities. If the spread between current ratio and acid test is increasing, you are building inventory.
Here’s why just the ratio — and not its trend — is dangerous: The industry average for current ratio is about 2. Let’s say your company’s current ratio in January is 3. You don’t worry about it because it is above the industry average. In February, however, it is 2.8 and March is 2.6.
You’re still not worried because you’re still above the industry average. But you should be worried. The trend is downward and it’s telling you that you’re becoming less and less profitable. You need to find out why and stop the bleeding!
If your current ratio is 2, your acid test should be 1 or higher. This means you probably have the correct amount of inventory. Every HVACR company has some inventory, even if it’s a few parts and refrigerant. Account for it properly and track it.
If you see your current ratio is increasing and your acid test is staying constant, this indicates that you’re building inventory. Find out why this is happening. If you just got a spring or fall stocking order, that explains the build up. You should see the spread between current ratio and acid test decrease as you use the inventory.
If a stocking order is not the reason, find out why you are buying more.
Net Profit Per Hour
The last clarity metric for me is net profit per hour. This metric answers the question: for every billable hour, how many dollars of profit are you generating? It’s not a percentage. It is a dollar amount.
Calculate it every month. Divide net profit by the number of billable hours. If your net profit per hour is less than $10, you could get a job at a fast food restaurant and earn more than you are earning in your business. If it’s negative, you’re paying your customers to maintain, service and replace their equipment. There are some slower revenue months that it may be negative. The overall net profit per hour each year, however, should be positive.
Only you can determine what net profit per hour you want to earn. Decide what you want, build your pricing around it and then track it to make sure your company is earning it.
There are other metrics that you can track, however, none are as important to your company’s profitability than current ratio, acid test, productivity ratio and net profit per hour.