Most small-business owners don't have financial or accounting backgrounds, yet they rely on a few critical numbers to help their companies survive and thrive. They'd rather make a terrific product or provide outstanding customer service than have to review their financial statements or analyze their company's financial reports.
But while your company may still be too small for you to hire a full-time CFO to manage the financial aspects, knowing your numbers is a necessary evil that comes with owning your own business.
The ABCs of Financial Management
Do you know your hypercritical numbers? Do you understand which figures and accounting principles are most important for the stability of your business? Here are some essential terms you'll need to understand before we dive into the key numbers you should be keeping an eye on:
- Balance sheet. A summary of your business’s assets and liabilities at a specific point in time. It's also referred to as a statement of financial condition.
- Income statement. A report that summarizes your revenue, or gross income, minus the cost of goods sold to determine your gross profit. It's also known as the profit and loss statement or P&L.
- Equity. The money or property invested and retained in your business by the owners and/or shareholders.
- Debt. Any loans taken by your business that must be repaid, usually with interest, over a period of time.
- Accounts receivable. The money your company is owed from sales of your products or services.
- Accounts payable. The money you owe to vendors and suppliers.
- Cash flow statements. A report that summarizes how much cash is going in and out of your business during a specific period of time. The statement is determined by analyzing operations, financing activities and investing activities to calculate your current cash on hand and predict future amounts. One of my personal favorite ways to generate numbers for a cash flow statement is the “quick ratio” or “acid test,” which works by measuring cash and accounts receivable divided by accounts payable (or current liabilities). A ratio of 2:1 or better usually means that you have effective cash flow management processes in place.
Why It's Critical to Understand Your Numbers
As the owner of a small company, you'll probably be the "chief cook and bottle washer" when it comes to accounting, financial management, budgeting and forecasting, at least for now. When you wear all those hats, you must be intimately familiar with the “blind spots” that could affect the viability of your business.
Every industry has a financial Achilles heel that, if not carefully managed and monitored, can cripple your company. For example, in the restaurant business, it may be your food and labor costs as a percentage of sales. In the retail industry, it may be rental charges or costs per square foot. In a consulting service, it may be revenues per professional. In manufacturing, it may be inventory turnover or percentage of defective returns.
No matter what your business is, you need to know your critical numbers, then build a dashboard to monitor them carefully and compare them to key industry ratios. So, for example, if your food costs as a percentage of sales are 41 percent and the industry average for a restaurant of your type and size is 28 percent, then that’s a red flag that something is very, very wrong. Your dashboard or scorecard will provide these yellow or even red warning lights that tell you when proactive remedial action is needed.
As it relates to the financial operations of a small business, the profit and loss statement tells the most important story as to how your business is performing. This is where the results of your company’s efforts and successes are most often expressed. As a result, many small-business owners won't focus as intently on their balance sheet and what story it's telling.
But that's a big mistake—you should be intimately aware of the details of your balance sheet and its relevance to your business's ability to execute on its business and growth plan. Drivers in this equation include items in your company’s operating cash cycle, such as investments in inventory, accounts receivable and other assets, offset by the amount of terms extended on payables. You should also understand how much every new dollar in sales requires in investment in additional working capital.
The fact of the matter is, all small companies will inevitably encounter financial or cash flow problems—it's not an if but a when. Having the right systems and business processes in place so your company has reasonable visibility and has the information available to help you make informed decisions when there's a problem is of paramount importance. The size and complexity of your business will usually dictate the types of business intelligence systems you'll need, but a process and a reasonable system for analyzing information is necessary even for a smaller, less complex enterprise.
There's an old saying that "We manage what we measure." Even owners of small businesses need to act "CFO like" when it comes to developing internal financial reports and dashboards. Get into the habit of producing reports, then reviewing the results by yourself and with your board of directors or advisory board, and the key leaders of your team to the extent that you're comfortable sharing financial information. Consider establishing a relationship with a coach, mentor or consultant with whom you can discuss your key numbers with candor and confidentiality.
Key Performance Indicators
Every business has a series of key performance indicators or KPIs. A KPI is a performance measurement tool that you can look at daily, weekly, monthly, quarterly, annually or on a project-by-project or division-by-division basis to help you measure and predict the overall health and efficiency of your company's operations. The effective use and interpretation of your KPIs can help you do a number of very critical financial management tasks:
- Define and measure the progress you're making toward your goals
- Make informed decisions as to budgeting and resource allocation
- Avoid being blindsided or surprised by weak results
- Detect fraud, waste or severe inefficiencies
- Give you the comfort you need to sleep at night and to face your lenders or investors with confidence
Remember that as your business grows, you may one day need to raise capital via the equity or debt route, and those sources of capital will want to see these reports and controls in great detail. The sooner you're capable of producing (and understanding) these reports, the more secure your foundation for growth.
Here are some of the most common key performance indicators that businesses use to monitor the financial health of their businesses:
Sales. Accurate sales figures are the first indicator of business trends. Whether they're increasing, decreasing or flat-lining, they provide a clear indication of where your business is heading. But they must be monitored in conjunction with bottom-line performance as well. Many small-business owners become too top-line focused and take false comfort in knowing that sales are growing even though margins may be shrinking.
Cash flow forecasts. You should calculate your cash flow forecast on a weekly or monthly basis; more often is better, especially during a growth spurt. The calculation goes like this: cash in the bank plus cash coming in over the next four weeks minus cash going out over the next four weeks. This number will reveal any cash shortfalls over the next four weeks and your ability to pay your bills at the end of the month.
Debtor days outstanding. This is the average number of days it takes for your customers to pay your invoices. The calculation goes like this: accounts receivable/sales multiplied by 365. A decrease is a positive sign, while an increase is an issue, as it will affect your cash flow and your ability to keep your creditors current.
Creditor days outstanding. This is the average number of days it takes you to pay your suppliers. The calculation goes like this: accounts payable/purchases multiplied by 365. This figure needs to be monitored in conjunction with your debtor days, as ideally, you would want the number of creditor days to be equal to or higher than your debtor days. If it's lower, you need to improve your debt collection, reduce your customer’s credit terms or negotiate better payment terms with your suppliers to avoid cash flow problems. This is one of the critical disconnects that can cripple a small company.
Inventory days or stock turnover. This is the average number of days the inventory you produce or purchase remains in your warehouse or on your shelves before you sell it. The calculation goes like this: inventory/purchases multiplied by 365. The lower the number, the better for your cash flow, which ultimately allows you to grow your business and expand your customer base without straining your resources. Inventory that's "collecting dust" is costing you money without a return and may be stale, obsolete or have been ordered in excess of demand. You need to carefully monitor what's moving and what's sitting and, most important, understand why. Stay close to your customers and meet often with your sales team to analyze and discuss any inventory that's stuck on your shelves.
Gross profit margin as a percentage of sales. The percentage indicates the price you charge your customers against the prices your suppliers charge you. An increase is generally a very good key indicator, but a breakeven number or a decrease should alert you that there are flaws in your business model or that overhead is too high or prices are too low.
Profit before income tax as a percentage of sales. Ideally this figure should increase, though a flat line may be acceptable for a period. A decrease, on the other hand, may be a warning sign of further potential losses.
Once you decide on the critical three to five numbers that will determine the success or failure of your business, begin to review and digest them on a daily basis, just as you do your morning coffee or vitamin regimen. These numbers should be shared, depending on your culture and leadership style, with others in the company who must also manage to them and should be the basis for daily huddles, brainstorming and longer-term strategic planning. These numbers can also form the basis for employee-level rewards and bonuses to help you drive business growth and the achievement of your business goals.
Andrew J. Sherman is a partner in the Washington, DC, office of Jones Day, with over 2,700 attorneys worldwide. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies, and is an adjunct professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University, where he has taught courses on business growth, capital formation and entrepreneurship for over 23 years. He is also the author of books on the legal and strategic aspects of business growth and capital formation.
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