Managing through clear eyes and KPIs
It’s a common scenario for a nanobrewery: One has a slew of numbers and data assembled in financial statements but isn’t exactly sure how to assemble them in a meaningful manner fitting their particular business model. To those who lack financial degrees and accounting backgrounds, it may often feel like closing one’s eyes before throwing a dart, hoping for the best while following instinct versus pragmatism. Additionally, owners often face making decisions quickly, without knowing where to start or how to prioritize their available resources, both in terms of time and money. In such a capital-intensive industry, it’s imperative we follow the path that brings the greatest return while conserving or boosting cash.
Cash is the key to our survival, especially with all the price increases we’ve faced in our industry over the past 12 months. We must know where to focus our time and efforts, the math behind each focal point, and the methodology to confidently make decisions to bring us the greatest amount of return. We must construct customized benchmarks and vet our own business models to ensure we’re operating at a sustainable level, while investing profits where we need them most without running out of cash over the long-term. It’s a balancing act, for sure, but it’s one we can certainly master if we know where to start.
Everyone should start with the balance sheet and we need to remember the basic accounting equation: Assets = Liabilities + Equity (ALE, how fitting). On one side we can see what the nanobrewery owns, while the other side shows how what we own was financed: Either through debt (loans) or through equity (paid-in capital). We can extract so much powerful information from this statement, but especially important for a rapidly growing nano we must calculate the following:
Working capital: Your current assets less your current liabilities.
This number should always remain positive and demonstrates what you have on hand to invest in your everyday operations. Take action to increase this number. If you’re a startup, be sure you’re in a positive position with three months of expected cash outflows on hand before you open those doors. Your working capital is the lifeline to your business and its importance can’t be emphasized enough. Too many breweries have failed due to their lack of focus on working capital.
Other key ratios to track that involve numbers from your balance sheet include:
Current Ratio (Current assets/current liabilities): Target 1.3 and higher.
Quick Ratio (Current assets less inventory and prepaids/current liabilities): Target 1.0 and higher.
Inventory Turnover (Cost of goods sold for the year/average inventory for the year): Higher numbers indicate increased efficiency. Lower numbers may indicate too much cash investment in inventory without high enough return.
Days’ Sales in Inventory (365 days in the year/inventory turnover for the year): The goal is to decrease this number over time by brewing as close to just-in-time demand as possible.
Debt-to-Equity (Total liabilities/total stockholders’ equity): This number indicates your brewery’s degree of leverage. It is not uncommon for a startup to show higher figures such as 20:1 in the very early stages, but the goal should be to get to 1:1 or less than 1:1. As that number decreases over time, this indicates that the nanobrewery’s profits are funding a greater portion of the brewery’s assets. As debt holds steady in the numerator, or falls through debt payments being made, the equity in the denominator rises as the brewery continues to add profit to its retained earnings. Most banks use this calculation to investigate debt service coverage and cash flow when a brewery is evaluating expansion. So if your nano is looking for its next, larger home, be sure to get this leverage ratio under control.
Turning our attention to the income statement, a best practice is designing or revising your chart of accounts to utilize divisional accounting. Think about how many distinct business lines you may have where you can measure revenue against cost of goods sold; where different profit margins should be segregated in order to analyze the health of that particular arm of the business. For example, one nano may have three lines of business: The brewery, taproom, and a kitchen. Therefore, you would want to design the chart of accounts to reflect those three lines of business and align them with the brewery’s defined success metrics. Once your chart of accounts reflects your specific business model, calculate the following ratios, then track their change over time:
Gross Margin: Gross profit/sales net of discounts, refunds, comps., etc.
Net Income %: Net income/sales net of discounts, refunds, comps., etc.
Return on Equity: Net income after tax/average stockholders’ equity over the course of a year.
Generally speaking, the higher each of those three results is, the healthier the operation. As every business model is different, a standard % or dollar amount can’t be specifically set across all. There is no one-size-fits-all magic number or % to hit. A sustainable gross margin for one may be treacherous for another. The goal, however, remains the same, regardless of business model: Take specific actions to increase each of those numbers over time and additional capital will become available to invest back into the brewery.
Finally, looking at the cash flow statement, understanding free cash flow is key as it is used by banks and investors in assessing the quality of a brewery’s earnings. Free cash flow is calculated as cash provided by operating activities less capital expenditures. It represents the cash a brewery generates after cash outflows to support operations and maintain its capital assets. Unlike net income, free cash flow is a measure of profitability that excludes non-cash expenses of the income statement and includes spending on equipment and assets, as well as changes in working capital.
The amount of cash flow from operating activities should always exceed net income. If the opposite were true, this could be an indication of possible overinvestment of cash in inventory or overly aggressive short-term debt repayment, when the cash could have been utilized much more effectively elsewhere. In other words, a negative result could be an indication of a mishandling of operations and an early warning beacon.
Understanding the debt-service-coverage ratio, calculated as EBITDA (earnings before interest, taxes, depreciation, and amortization) divided by total debt service (principal plus interest of debt owed over the upcoming 12 months), is also crucial. It is a measure of the cash flow available to pay current debt obligations. A 0.85 debt service coverage ratio (otherwise known as DSCR) means the brewery can pay only 85% of its annual debt obligations. Most banks working with breweries seeking to open or expand in 2023 will look for a 1.2 DSCR to approve new loans.
The key takeaway here is to focus on those activities that generate the fastest cash inflows. From the sales, general, and administrative perspective, multiple actions may be taken. For starters, understand your prime costs, the sum of all labor and cost of goods sold, as they’re controllable, and take actions to ensure they don’t skyrocket over time as a percentage of total revenue. Try to limit occupancy costs to 12–14% of total revenue and renegotiate lease-to-sales targets if at all possible.
At the end of day, working capital is the cheapest and fastest source of cash to invest back into our brewery, as it is interest-free and bears no conditions. Therefore, managing it should be our priority. Some best practices to managing working capital include:
- Managing our inventory levels by calculating inventory turnover and days’ sales in inventory regularly
- Streamlining and centralizing ordering whenever possible
- Reviewing pricing and contracts regularly
- Optimizing stock levels based on forecasted demand
- Practicing just-in-time management by knowing your optimal reorder points and optimal order quantities
- Paying vendors on time to strengthen our negotiation stance and obtain better terms and pricing
- Improving receivables collection and vetting debtors before doing business with them
So now that we’ve looked at some key financial ratios using our financial statements, let’s move on to building a dashboard that includes key performance indicators, or KPIs, so that we can view our brewery in a single source, flash report. But before we do so, let’s take a small step back to talk about KPIs specifically. By definition, KPIs are simply a set of quantifiable measures that a brewery uses to gauge its performance in terms of meeting strategic and operational goals over a specified time period. Sounds simple enough, but any brewery owner who’s ever attempted to nail down their KPIs can tell you that determining which factors are really driving your brewery isn’t always straightforward. I’ve witnessed several breweries spending months tracking metrics that turn out to have little or no impact on actual results because they didn’t take the time to define their success metrics first. Focus on expressing those success metrics with your team, then aligning KPIs with those success metrics to drive accountability and buy-in by all involved. We’re such a capital-intensive industry that we need to focus on how effectively and efficiently our assets are utilized to produce a return on our investment. Because of the pandemic and often unforeseen circumstances, we should be focused on generating positive cash flow from our operations. We need to know how quickly we can turn sales into cash and how long our cash is invested in inventory.
We’ve covered many of those classified as financial KPIs above, but KPIs can also be operational to offer us insights on our safety, quality, and productivity.
Some of the more common production-oriented KPIs I see utilized within our industry include the following:
- Total production yield by batch (our brewhouse efficiency)
- Product loss percentage through production and packaging (tracked separately to gauge efficiency)
- Capacity utilization (a measure of efficiency and planning for additional fermentation options)
- Barrels produced per employee (to understand overhead)
- Barrels produced per production employee (to understand labor productivity)\
- Production labor dollars per barrel brewed (to construct an income statement on a per barrel basis for setting pricing)
- Dumped/dated beer in barrels (to address quality concerns)
- Raw materials per barrel produced (to be able to construct an income statement on a per barrel basis for pricing)
A tool to assist with the raw materials per barrel produced calculation and how it comes into play with our pricing, can be found below.
Turning to sales KPIs, I often see the following being included as part of the nano’s dashboard:
- Total sales in barrels
- Net revenue per case equivalent by beer style
- Net revenue per case equivalent by sales channel (if the nano self distributes outside the taproom)
- Net revenue per employee and by package type (to assist with staffing the taproom and with possible variable compensation planning)
- Depletions to retailers (if self distributing)
- On-premise mix by style and package type
- Off-premise mix by style and package type
- Taproom: Average guest tab
- Taproom: Average pints poured per hour (to assist with staffing levels)
- Taproom: Sales volume by day and hour (to assist with staffing levels)
Once we’ve aligned our KPIs with our strategic goals and define the current value and the target we are striving towards, the next step is to define the data collection steps and the platform to be utilized for tracking and communication. Some use a spreadsheet in a Google shared drive while others prefer the visual appeal of inexpensive online platforms one can access on their phone or tablet. From that point forth, set an update frequency most fitting to your nano’s operating hours. I most often see KPIs being reviewed as a combination of weekly and monthly as either part of a standup or a weekly leadership team meeting.
The important reminder is to be consistent, hold people accountable to meeting those KPIs via their explicit rights and roles, analyze expected versus actual results as a team, and take action. Hold your team and yourself accountable to meeting those targets. Sometimes it’s tough to stay positive when goals are audacious, hairy, and long-term. Your team will feel empowered to make a difference when they see the needle move, so breaking down the more ambitious, larger goals into its key drivers will give them the opportunity to achieve each in stages. Focus on those baby steps and celebrate together to keep morale high. Good luck!