Let’s face it – managing your business finances can be overwhelming. And, if you’re like most business owners, you want to focus on your own products and services, not on crunching the numbers!
But it’s critical for you to know about the financial health of your business. So, we’ve taken a few moments to break down some of the most important numbers for you to understand. It can vary for each individual company and industry, but if you have a good understanding of these numbers, then you’re off to a great start!
What is it?
Cash flow is the actual money moving in and out of your business every month.
Why is it important?
Your cash flow provides a “big picture” view of your business’ financial health. Lack of cash flow is one of the most common reasons that small businesses fail.
But cash flow is more than just profit or loss. Inventory, debt, accounts payable, delayed payments from clients, and other factors can also play a role. For example, you may find yourself in a situation in which your income statement shows that you profited last year, but you still don’t have enough money to pay all of your bills. But your money could have gone towards an increased stock of inventory to prepare for your busy season, a new piece of equipment, or interest on a loan payment.
How can I fully understand my cash flow?
Make a chart of where all of your business money goes – inventory, equipment, salaries, benefits, rent, loans, taxes, advertising, etc. This should include one-time expenses, as well as regular, monthly payments. Then, you’ll be able to sit down and determine how much money you need to make each month to cover all of those expenses. Cash flow tools (like this one, from Excel) can help you map out your expenses and income.
But unexpected expenses can come up when running a business! You should always try to have enough money in your bank account to cover 3-6 months of expenses in case of emergency.
Profit and Loss Statement
What is it?
A Profit and Loss statement, often referred to as a “P&L”, summarises your income and expenses during a given time. So, you might generate a P&L quarterly, monthly, or even weekly.
It’s a barebones, basic statement that answers the question, “Am I making money or losing money?”
Why is it important?
This can be used as a snapshot to review your performance and whether your business efforts are improving or headed in the wrong direction. It cuts out all of the other information that can be distracting when you just need a simple review of your performance.
Gross Profit Margin
What is it?
Gross Profit is the difference between the amount you sell an item for and how much it costs you to make the item, buy it wholesale or delivery a service (think a lawyer doing legal work). Gross Profit Margin gives you a ratio or number to aim for other than a dollar amount – which is useful in a variety of circumstances.
So, if you sell 10 t-shirts for $140, and your cost to make the shirts was $100, the $40 that remains is your gross profit.
To find the gross profit, you divide that $40 by your total revenue. This gives you .285 or 28.5% gross profit margin.
Many businesses aim for a specific gross profit margin like 40%. This might be something they decide for themselves, or it might be based on an industry standard.
In general, this number should stay relatively stable. So, even if you go from $10,000 to $100,000 in sales, your gross profit margin should stay close to the same.
Why is it important?
Sometimes, if your pricing varies, or you have a lot of discounts or promotions, it can be tricky to make sure that the increase in sales is actually making you more money. So, if you doubled your revenue this month and your gross profit margin stayed the same, that’s definitely a good sign.
It also helps you to price your products if you have a large inventory of different kinds of items. When determining what to price an item, you can have a minimum margin in mind. So, if 40% is your minimum gross profit margin, and the item costs $6.00 to make (or acquire wholesale), then you would price the item at $10 or higher.
Like a net strains out all of the water and just leaves you with the fish, your net profit is the money left over after all of your expenses are accounted for. So, remember that gross profit is the amount left over after you subtract the expense of a particular item. If it costs you $10 to make and you sold it for $14, your gross profit is $4.00.
Net profit takes it a step further to account for all of your other operating expenses.
Let’s say you rent a booth at a festival and you sell 100 t-shirts like the one above – your gross profit is $400.
Then, consider the cost to rent the booth: $150
Costs for transportation + other miscellaneous costs: $50
Net Profit: $200.
Net profit is the number you’re really looking for. If you make gross profit, you’re on the right track. However, if you add up your other expenses and you have a net loss, you’re on the way to going out of business.
This is a common term, and you may hear people say that it’s a “Snapshot” of your business at specific point in time.
That’s because a balance sheet takes into account all of your company’s various assets and liabilities and ties them together. It can help you see, “How much is my company worth right at this moment?”
So, on January 1st, you might have some money in the bank, some invoices that clients haven’t paid, and money being transferred to your bank that hasn’t yet reached you.
You might also have bills that you owe that you haven’t paid yet. Or a balance owed on an investment like a company car.
However, you also have some fixed assets like computers that belong to your company – these have a positive value as well.
A balance sheet takes into account all of these factors and gives you back a number.
This is important because you can be deceived by your bank account. Perhaps it’s full and things look great, but you actually have a ton of unpaid bills. Or, maybe you’re short on cash but a bunch of clients are about to pay you. This takes all of that into account.
Inventory Turnover Ratio
What it is:
This can be tricky, but doesn’t necessarily have to be. The inventory turnover ratio measures how much of your inventory you typically turn over in a given period of time.
First, you need to know your average value of inventory. So, if you usually have $1,000 of inventory on hand (average), and over the past year you’ve sold $10,000 – your ratio is 10.
Why it’s important:
This measures how efficient you are at handling inventory. You don’t want to have more inventory on hand than is needed because it uses more space to store (and costs more) and adds risk if you have trouble selling items. Of course, you also don’t want to run out. So, you want to be adding and selling (turning over) inventory as efficiently as possible, giving you the highest possible number.
For larger businesses, you might even use inventory as collateral for a loan. Banks will take a long look at your inventory turnover ratio when deciding how much that inventory is actually worth.
If you say, “Look I have $1,000,000 in inventory that’s already paid for and I want to use it as collateral”. The banker might see that your turnover ratio is .33 and so only 1/3 of that can be expected to be sold in the next year, thus lowering your expected revenue and decreasing the value of your inventory as collateral.
Maximum Earning Potential
If you offer a service, you can use this to help price your services and gauge how efficiently you’re operating.
Suppose you have 40 available hours in a week. 10 of those you set aside for administrative and marketing tasks. So, in a given week, you can work a maximum of 30 hours.
If your hourly rate is $10, you can only make a maximum of $300 per week. If you work 50 weeks per year, will this be enough to sustain you? What hourly rate would it take to maintain your lifestyle?
Once you’ve set your rate, you can take the revenue generated and divide by the period of time to see how efficiently you’re working.
If your rate is $20 an hour and you billed $500 this week, you’d divide 500 by 600 (30 hours x $20 per hour) to get a “Score” of 83%. This either means that you only sold 83% of your “available” time, or that you only worked efficiently for 83% of the time!
Like I said at the beginning, every situation is different. However, once you start to understand these numbers, you can use them to improve the health of your business. Maybe you’ll notice that you should keep less inventory on hand, or that you need to increase your hourly rate to account for your realistic level of efficiency. Maybe you think you’re too low on cash and are about to close, but your balance sheet shows you that you are in good shape once you receive your invoices!
Whatever it might be, you’ve got to know your numbers because you’re in business, right?
Many business owners find that hiring an accountant is well worth the money. They can help you spot trouble (and avoid it) and give you back a whole lot of time so you can focus on what you do best. If you are a business in Australia with a lot of inventory, you might use MYOB EXO. I have a website with free MYOB Exo Training, including dozens of video tutorials, and I also offer one-on-one consulting to help you maximize your use of this platform.
If you can’t afford an accountant yet, there are many tools that you can use which will give you these basic reports. Then, you can refer back to this guide to see what each one means and why it’s important!
*** This Guest Post was from Brendan Mills ***
Brendan Mills is the founder of CFO Dynamics and loves helping businesses maximise their financial performance by optimising their financial processes.
His great passion is to help people understand financial information and use it to their advantage, regardless of how much (or how little) financial experience they have.