Perhaps you use Google Analytics to track every visitor to your website, right down to the country they’re visiting from. Maybe you even use wearable technology and a smartphone to measure the steps you take in a day or how much sleep you get at night. But what are you doing to measure the financial health of your business? If your only measure of financial performance are the sales you generate each month or the balance in your bank account—you’re missing out on a wealth of information about your business.
Financial statements and metrics are more than just numbers that go up or down month after month: they tell a story about your financial health, your ability to grow, and your ability to sustain and weather trying times. This information can help you build an awareness about your business finances. For most of you, it will make sense to “check in” at least once a quarter, if not monthly. When you look at things too frequently, small variances can be distracting. So it’s better to set a regularly spaced rhythm for monitoring your financial health and to watch the patterns and trends that emerge.
The three core financial statements you should review regularly are your Income Statement (or profit and loss report), Balance Sheet and Statement of Cash Flows.
1. Income Statement
The Income Statement is designed to show your income and expenses over a period of time. It’s like a video capturing all the changes that take place over a period of months or years. Any discernable type of revenue you generate should be listed first, followed by all expenses broken down by category. Pay special attention to the two margins: gross margin and profit margin. Your gross margin should identify how much it costs you to produce every dollar of goods or services you sell. And the profit margin is what’s left after paying all the other expenses of the business (overhead, salaries, taxes, etc).
2. Balance Sheet
The Balance Sheet shows your assets, liabilities and equity as of a particular date. It’s more like a picture of a snapshot in time. The logic of a Balance Sheet is that your assets always equal your liabilities plus your equity—which makes sense when you think about what those words represent. Assets are all of the “things” your business owns: money in the bank, real estate you’ve purchased, buildings, equipment, furniture and intangible assets such as patents. Liabilities are all of the things you owe to other people: loans that must be repaid, credit card balances and unearned portions of revenue you collected.
Equity refers to parts of the business you own outright: the capital you and others contributed, and the accumulation of all your profits. Expressing this a different way, everything you have in the business (your assets) you received in one of two ways: either by borrowing the money to get it (liabilities) or earning it (your own money or your business profits). And if you had to liquidate the business immediately, you would turn all of your assets to cash, pay off all of your debts and be left with your equity.
3. Statement of Cash Flows
The Statement of Cash Flows is often the most neglected of the “big three” financial statements, but it tells such an important story. If you started the quarter with $200k in the bank, and your Income Statement told you that you had a profit of $150k, you would expect to see $350k in the bank now, right? The Statement of Cash Flows explains all the non-Income Statement ways that your bank account balance is affected.
To make the most of the “big three,” there are many financial ratios you can use to add more context to your financial data. Here are a few key metrics you can look at to measure your financial health:
Liquidity: Though many measures of liquidity exist, one that you can focus on immediately is the Current Ratio. The formula for calculating this is: Total Current Assets / Total Current Liabilities. It helps express your ability to cover all of your short-term debts with your readily accessible assets. A measure of 2:1 or more is generally considered healthy.
Cash Flow: Your cash flow ratio is calculated using the following formula: Cash Flows from Operations / Total Revenue. For example, a cash flow ratio of 23.49% tells you that for every $100 of sales you have, you are generating $23.49 in operating cash flow for your business.
A/R Collections: Accounts Receivable Turnover is a more complicated measure to calculate, but the results can be very telling for many business owners. The formula is Net Credit Sales (no cash sales included) / Average Accounts Receivable (average A/R is beginning plus ending divided by two). The number that is generated shows you how many times in a year you turn over your Accounts Receivable. For example, an A/R Turnover of 3.33 tells you that your accounts receivable is turned over 3.33 times in a year, meaning it takes you an average of 110 days to collect the money your customers owe you. Would you be happy with that figure? Set your own goal that works for your business.
Profitability: Possibly one of the most useful metrics around, your Profitability Ratio is expressed as: EBIT / Total Revenue. EBIT is your earnings before interest and taxes. What this powerful measure tells you is the amount of profit you are creating for every dollar in sales. For example, a Profitability Ratio of 12.5% means that for every $100 in revenue you create, you are actually putting $12.50 back in your pocket. Think about the Profitability Ratio you would need to meet your goals.
Returns: The two most common expressions of economic return are Return on Equity and Return on Assets. But let’s look at another measure that might have even more value to a business owner: Return on Capital Employed (ROCE). Your ROCE is calculated like this: Annualized EBIT / Total Invested Capital. This calculates the return on the owner’s capital investment and can help you measure how quickly you are adding to your net worth by operating this business.
The business development cycle is about Innovation, Quantification, Orchestration. The more you can find ways to try new financial structures or systems, quantify the impact they have on your business, and then orchestrate them into your overall business system, the closer you’ll be to owning a real “money making machine.”
If you’re looking for some industry benchmarks, try Bizstats or Yahoo Finance. And if you need a tool to help automate the calculating and monitoring of your ratios, try Fathom. It does a great job of reading your financials and providing you with the financial insights you need so you can spend your time figuring out how to improve your most valuable metrics.