Every business owner wants to make more money and maximize profits. The problem is that many business owners don’t know how to manage the finances of their business or what levers to pull to improve overall profitability.
One of my business owner clients put it like this:
“I never had a problem making money. Revenue was not a problem. But making good money was a new concept to me. Good money was leveraging the productivity of my people to make more gross margin dollars and managing expenses in a way to increase profitability. That was all new to me. When I got into the rhythm and cadence of a monthly financial review, I knew I needed a coach.”
To make good money you need to know how to analyze your financial statements and create metrics to measure. Specifically, those metrics are profitability, asset quality (receivables and inventory), liquidity, and leverage.
Your balance sheet is more important than your income statement. Three of the four things I just mentioned (liquidity, asset quality, and leverage) are reflected on the balance sheet.
Liquidity
There are several ways to measure liquidity. There’s a current ratio, a term called working capital, and then my favorite, days sales in cash.
- Current ratio is current assets/current liabilities and working capital is current assets – current liabilities. The higher the number, the more liquid you are. If the number is negative, that should be a red flag that you have a liquidity problem.
- My favorite is days sales in cash. You’ve heard the phrase “Cash is King”. So, I take sales and come up with a daily number. If you’re six months into the year (180 days) you take sales $1 million/180 days= $5,555 sales/day. I take my cash balance of $100,000/$5,555 = 18 days sales in cash. 3-5 days sales in cash, you have a liquidity problem. 15-30 days is a nice cushion.
Asset quality
- Receivables go up do either due to sales growth, a slowdown in collections, or a combination of the two. It can also be due to receivables that should be written off.
- The best metric to use to calculate receivables is the AR turnover ratio (annualized sales/accounts receivable = AR turn expressed as a number.) To convert that turn to actual days takes 360/the turn.
Ex. $1 million annualized sales and your AR balance is $100,000. $1 million/$100,000 = 10, then calculate it in days 360/10= 36 days. So, your receivables are turn 10 times a year and you have 36 days in outstanding AR. - When you have revenue growth, if the turn is the same (36 days), then the increase in receivables is due to sales growth. If turn slows down, then part of the increase is due to slower collections. You have to do the analysis to determine the cause and effect.
Leverage
- Leverage is the amount of debt you use in your business. If you use other people’s money plus your own, you can grow faster. However, during a recession, it causes you decline faster too because you’re having to fund losses and pay back debt.
- Leverage is calculated by total debt/total equity or net worth. If you’re trying to borrow money from a bank, don’t let your leverage ratio go above about 3-1. Banks want to see the owner taking an appropriate amount of the risk.
- Leverage increases when debt is increased or equity is decreased. Equity is decreased by losses or excessive distributions by the owner.
Depending on which of these three you want to improve, you will implement a strategy or process to address it. Like the business owner I mentioned at the start, it’s important to get into a cadence and rhythm of a monthly review to work on the business and track the ratios to monitor your performance.
If all of this seems a little overwhelming, you can always hire a coach to help get you started and then take it over when you feel comfortable monitoring it yourself.
P.S. If a monthly financial review is brand new, I suggest a Business Financial Check-up to determine a baseline of where your business is today. Without a baseline, you don’t know if your business is getting better or worse, making future performance difficult to evaluate.
