Taking the Temperature of Your Small Business's Financial Health
As an entrepreneur, you fulfill many roles in order to keep your business going. And when it comes to your business’s finances, it’s time to grab your doctor’s bag and take the temperature of your financial health.
To help ward off the out-of-business bug that infects the overwhelming majority of small business owners, we’ve identified five measurements that can gauge the well-being of your bottom line—and provided the prescriptions you’ll need to improve what ails your business.
1. Get Back to Accounting Basics
You can’t assess your financial situation if your records are outdated (or nonexistent). If you cram receipts into shoeboxes and record daily transactions on cocktail napkins, it’s time to upgrade and standardize your accounting system.
At the heart of every accounting system beats a general ledger. All your daily journals, such as sales and cash receipts journals or cash disbursement journals feed into the general ledger. You can create a series of spreadsheets and worksheets to accommodate all your journals, or you can save yourself some headaches and opt for a mobile app or small business accounting software (which we highly recommend). Either way, the end goal is twofold:
- to record all your transactions consistently and promptly
- to use your data for analyses and predictions
Of course, spreadsheets or accounting software will provide a fine way to fulfill the former. And while you can cobble together formulae across spreadsheets to complete the latter, accounting software makes analyses and predictions far easier.
Accounting software also better ensures accuracy by using double-entry accounting, a system where every recorded transaction contains a debit and credit component. This system is preferred by accountants, recommended by the Toolkit editors and often required by the IRS for tax-compliant accounting methods.
Regardless of the system or entry method you choose, remember the most important part: Keep your records up-to-date. As the adage goes, you can’t improve what you can’t measure.
2. Check Your Liquidity
Just like you keep a certain portion of your personal assets liquid at all times (we hope), you’ll want to measure how much of your business’s capital is liquid at any given point. To properly check the liquidity of your business assets, you can use a series of liquidity ratios.
These ratios are among the most common of all business ratios. They are designed to measure your business’s ability to pay off short-term debts with cash on-hand, hence the importance short-term lenders place upon them. Some banks or other lending institutions will require you to maintain a specific minimum ratio.
The most common liquidity ratios are the current ratio (which demonstrates your business’s ability to generate cash to meet short-term obligations) and the quick ratio (which resembles the current ratio except inventory is not included in your current assets).
To find your current ratio, use x:y, where x represents the amount of current assets and y the current liabilities.
If your current assets including cash total $50,000 (x) and your current liabilities comprise $25,000 (y), your current ratio is 2:1.
A current ratio of 2:1 or higher is generally considered sound.
If yours is lower (such as 1:3), consider obtaining a long-term loan to pay off enough of your short-term debt to achieve a minimum 2:1 ratio. If your rate is spot on or higher, you can use your cash to pay down the short-term debt to achieve an even higher current ratio. You would also be prudent to consider investing some of your available cash.
Of course, the current ratio makes one big assumption: You can sell off your inventory easily in order to pay your short-term debts. But, as you already know, that’s not always possible. The quick ratio shows how liquid your finances are in a pinch and if you’re keeping too much inventory on hand.
Quick Ratio. To find your quick ratio (also called an “acid test”), let x represent your current assets minus inventory and y your current liabilities.
If your current assets excluding inventory come to $75,000 (x) and your current liabilities equal $25,000 (y), your quick ratio is 3:1.
Considering a quick ratio of 1:1 is good, the example above is excellent. If your ratio, however, shows the opposite (maybe only $25,000 for x and $75,000 for y), take immediate action. Like fixing a current ratio, you can take out a long-term loan to pay off your short-term debt. Or, if the market is good, sell a portion of your inventory without ordering replacement stock in order to build your current assets without increasing your current liabilities.
Once you have a handle on your liquidity ratios, you can refine your cash flow budget.
3. Put Your Income Statement to Work
By analyzing your income statement (also called a profit and loss statement), you can find key insights into sales growth, attrition, expenses and more. This statement contains your company’s gross revenue (the “top line”) minus all expenses to show the profit or loss (the “bottom line”). Income statements are limited to fixed periods, usually three fiscal years.
By now, you’re probably seeing the value in getting your books up to snuff. Without maintaining meticulous records, you can’t produce an accurate income statement. And without an accurate income statement, you can’t properly diagnose your financial health.
Most income statements include three years of data and contain sales, costs of goods sold and expenses, like this example:
|Smith Manufacturing Company |
Years Ended December 31, 201Z, 201Y, and 201X
| ||201Z ||201Y ||201X |
|Sales ||$ X ||$ X ||$ X |
|(Sales returns and allowances) ||($ X) ||($ X) ||($ X) |
|Net sales ||$ X ||$ X ||$ X |
|Cost of goods sold |
|Beginning inventory ||$ X ||$ X ||$ X |
|Cost of goods purchased ||$ X ||$ X ||$ X |
|(Ending inventory) ||($ X) ||($ X) ||($ X) |
|Cost of goods sold ||$ X ||$ X ||$ X |
|Gross profit ||$ X ||$ X ||$ X |
|Selling expense ||($ X) ||($ X) ||($ X) |
|General and administrative expense ||($ X) ||($ X) ||($ X) |
|Total operating expenses ||$ X ||$ X ||$ X |
|Income from operations ||$ X ||$ X ||$ X |
|Interest expense ||$ X ||$ X ||$ X |
|Pretax income ||$ X ||$ X ||$ X |
|Income taxes ||($ X) ||($ X) ||($ X) |
|Net income ||($ X) ||($ X) ||($ X) |
|(Here you put relevant notes, which are an integral part of this statement.) |
If you can’t produce three years’ worth of data, produce however many years you can. You can always use quarterly information if years aren’t available. Unless your business is seasonal, quarterly information can suffice.
Just glancing over the statement often reveals areas to investigate, such as sales steadily declining or expenses drastically rising. But to discover if your profitability is sound or sick, you’ll want to calculate your gross profit margin.
To determine the gross profit margin, divide your net income by your gross profit (net sales).
Consider these three years’ worth of data.
| ||Year 1 ||Year 2 ||Year 3 |
|Gross Profit (Net Sales) ||$125,000 ||$126,000 ||$123,000 |
|Expenses ||$50,000 ||$53,000 ||$56,000 |
|Net Income ||$75,000 ||$73,000 ||$67,000 |
Our gross profit margins (net income divided by gross profit) for each year are as follows:
Year 1 — 0.6 (60%)
Year 2 — 0.58 (58%)
Year 3 — 0.54 (54%)
While these gross profit margins are very high, they are trending down. And, as you probably noticed, the year with record sales did not boast the highest gross profit margin ratio.
Monitor these ratios closely to ensure your margins remain steady or, hopefully, increase. When it comes to your gross profit margin, you can abide by two universal truths:
- without effort, your sales will likely decrease
- without question, your expenses will likely increase
If your margins are slipping, or fall within an unacceptable range, remember the trick isn’t always boosting sales. If a boon in sales also results in a boon in expenses, nothing has improved. The key is to raise sales while stabilizing or decreasing expenses. That may sound like a pipe dream, but you can curb expenses by taking measures such as:
- cancelling service contracts that add no value
- outsourcing services, especially ones that currently keep you from growing your business
- calling current vendors to ask for reduced rates (it does work!)
- implementing no-cost social media marketing and advertising programs
Leave no stone unturned as you investigate ways to cut expenses and increase sales. Don’t be afraid to question the necessity of anything. Asking tough questions about the status quo is, after all, what makes you an entrepreneur.
4. Investigating Your Inventory
Many small business owners err on the side of maintaining (far) too much inventory. This strategy might make for happy customers who never have to worry about anything being out of stock, but it demands a great portion of your cash flow.
To keep your inventory at the right level and improve you cash flow, calculate these helpful ratios:
- the average inventory investment period, which shows time needed to convert a dollar of cash outflow, used to purchase inventory, to a dollar of sales or accounts receivable
- the inventory-to-sales ratio, which focuses on your investment in inventory in relation to your monthly sales
Average Inventory Investment Period. The first step to evaluating the financial health of your inventory lies in the average inventory investment period. Here you can see the average time needed to convert the money invested in your inventory into what you really want: sales. To find this investment period, you’ll need to divide your present inventory balance by your average daily cost of goods sold. If you don’t know your average daily cost of goods sold, simply divide your annual cost of goods sold by the number of days you’re open annually.
If, over the course of one year, your business sold off inventory for which you paid $113,500 and was open 355 days (closed for 10 holidays), your average daily cost of goods sold is $320. If your inventory balance remaining at the end of the same year was $37,000, your average investment period is 116 days.
Average daily cost of goods sold — $113,500 / 355 = $320
Average inventory investment period — $37,000 / 320 = 116 days
You might be thinking 116 days seems like an awfully long time before that money spent on inventory turns into sales. If so, you’re on the right track. Any steps you can take to reduce the number of days in this period results in more cash flow. If you ordered less to the point where you could reduce your inventory balance to $26,000, your average inventory investment period would drop to 81 days and add $11,000 into your cash flow. That may be a lofty goal, but remember that any inventory you can delay ordering without affecting your customer experience is a positive step toward a reduced average inventory investment period.
Inventory-to-Sales Ratio. Unlike the average inventory investment period’s focus on the past year’s events, the inventory-to-sales ratio reveals your recent monthly inventory trends. To calculate this ratio, use x:y, with x representing a month’s inventory balance and y its total sales.
If your business maintained a $15,000 inventory balance (x) at the end of June and earned $10,000 in sales (y), your inventory-to-sales ratio is 3:2.
Of course, this ratio, out of context, doesn’t offer any insight. But when tracked on a monthly basis, it can shed light on inventory trends. Be wary of an increase in this ratio, as it means one (or both) of the following is hurting your business:
- your investment in inventory is growing more rapidly than sales
- your sales are dropping
As you calculate this ratio on a monthly basis, look to see if you need to start ordering less or finding ways to spur your sales.
5. Assess Your Debt Levels
Risky Business isn’t just a Tom Cruise movie. You must weigh the financial risks of your decisions every day, especially when those decisions involve increasing your debt load. To see what new debt obligations will mean for your business—or to see if your current ones are acceptable—you can calculate a series of solvency ratios. The two most important, though, are your debt-to-equity and debt-to-assets ratios.
Debt-to-Equity Ratio. Once you have your balance sheet, you can determine your debt-to-equity ratio of x:y, with x representing your total debt and y your equity in the company. If your business owes $100,000 in debt (x) and you possess $25,000 in equity (y), you have a debt to equity ratio of 4:1.
Like many of the previous examples, the lower the ratio, the better. If your ratio level rises over time, you’ll need to find a way to curb its growth. It might just be a matter of adjusting the paperwork, such as deferring expenses or bonuses beyond the balance sheet date if possible. If you are able to use cash to pay down debt, it might be a good option. Besides having your business look better on paper for potential investors, a low debt-to-equity ratio gives you more flexibility to expand as the opportunity arises and take on more debt as the need surfaces.
Debt-to-Assets Ratio. You can find your debt-to-asset ratio with x:y, with x representing your total debt and y your total assets. If your business owes $100,000 in debt (x) and you possess $50,000 in assets (y), you have a debt to asset ratio of 2:1.
Maintaining a debt to asset ratio of 2:1 or lower is your best bet. Anything higher can result in difficulties making your debt payments. To lower this ratio, your options are admittedly a little limited. You can pay down your debt and explore ways to increase the value of your assets, such as improving your facility (if you own it) or having your inventory appraised. The latter, though, may backfire and decrease the value of your assets.
While all these steps will help you run your business more profitably and efficiently, they will also be instrumental in improving your odds for receiving a loan and helping you plan your business strategy. But as helpful as these tools might be, they will change as your business changes. You’ll need to re-evaluate them regularly, at least on a quarterly basis. Don’t wait until your business is in dire straits before taking its financial vitals.