By Brian Hamilton
The beginning of a new calendar year is a good time to take stock of your business’s financial health with a business checkup. And while you may be tempted to think about your financial statements only during tax time, smart business owners will use their financial information anytime they are making a decision about their business. You should consult your accountant for advice at least two times per year – not just during tax season – since he or she will be able to point out the reasons why your business is succeeding (or not).
Try a self-assessment to kick off 2014. Here are three things to look at in order to quickly get a pulse on how your business is performing.
In general, as business owners, we tend to focus on raw dollars and not necessarily on margin management. At Sageworks, when analyzing the health of a business, we always ask, how strong are the margins? I can’t think of a more important profitability metric than operating margin. It measures how many cents of profit you’re earning on each dollar of revenue you make, and it’s a very strong indicator of how much cushion your business has if your sales go down. This plays into how easy (or difficult) it will be to scale your business. Changes in margins related to profitability, like operating margin, typically have cascading effects across other financial metrics, and will tell you a lot about your company’s health.
Equally as important as showing solid profit growth is knowing how you got there. How much time and money are you spending on your product or service for each dollar of revenue that you generate? There is usually a direct relationship between your inputs and outputs (returns) and being able to identify how you’re doing now and whether or not your current strategy is sustainable. Knowing this information is key as you grow your business.
2. Cash Flow
The cash flow statement tends to get overlooked, not just by business owners, but by finance people too. It may, however, be the most important source of information about your business’s financial health. The main line item to look at is cash flow from operations. This metric shows, over a certain period of time, how much cash went into and out of your business on an operating level; it pulls information from both the income statement and the balance sheet.
Many business owners make the mistake of thinking that profits are equal to cash, but this is almost always an incorrect assumption. If you’re selling $1,000 of your product, but all of those sales are in accounts receivable, you can’t use those funds to pay your bills or invest back into your business until you collect. This may seem like an obvious point, but in my experience working with companies in banking and consulting, I find that most businesses owners struggle to get a strong command of their cash flow.
Unless you can maintain positive cash flow, you will always be worrying about paying the next bill rather than focusing on growing your business. Looking at cash flow from operations on a regular basis will help you keep a pulse on the health of your business.
It isn’t enough just to have solid profitability and cash flow metrics. You need to put some kind of system in place to help you track your business’s performance for one month, a year, or even five years into the future. I like to use the analogy of checking the air in your tires. The time to know whether or not you have enough air is before you get on the road, not when you’re already driving 75 miles per hour on I-90.
There are many tools for doing this, but I would recommend in most cases that you select a financial tool or model that allows for adjustments so that you can recast your projections based on other variables and costs, which will change over time.
A Few Tips for Using This Checklist
Many business owners tend to make gut decisions, which is not always bad. But using the information available to you, specifically your financial data, to evaluate business decisions is a bandwagon worth jumping on. You should always be looking at the financials first, and then making decisions.
When you review your financial statements, whether you do this with your accountant or on your own, always focus on how the various metrics affect your profits and your cash flow. Every analysis of your business’s financial metrics should relate back to how you can increase your profitability and cash flow – the two measurements that matter most.
I find that entrepreneurs are usually very good at the daily operations of their businesses, but understanding their financial statements is not as obvious to most of them. It’s similar to getting a medical exam, or if you’re overweight, getting on a scale – it’s something you might not want to think about. However, having a basic understanding of some simple metrics that you can review regularly, and more importantly, track over time, will help you make better decisions for your business.
Understanding your company’s financials should be on every entrepreneur’s list of New Year’s resolutions.