How to Evaluate Your Company’s Financial Position
The Great Recession has made checking in on the basics of your company's financial position more than just a to-do item: it's become an absolute necessity. Unfortunately, understanding how healthy your company is financially takes more than just logging in to your online bank account and checking balances. And that's where most entrepreneurs get turned off. Who wants to really dig into those complicated balance sheets and income statements anyway? Isn't that what I have an accountant for?
In general, yes, you should have a competent CPA to help you organize the financial details of your business. But that doesn't let you off the hook: as the leader and/or owner of your business, the onus is on you to make sure you're headed in the right direction. The good news is that you don't necessarily have to fully immerse yourself in those financial statements to take your company's financial temperature.
What you do need to do, however, is look at a combination of both financial and operational metrics that benchmark your company's current financial performance against your competition and your own past results. Start by taking a crash course in understanding your company's critical numbers. Then, consider these tips on a few additional metrics that will help your company stay on the right financial path:
Scrutinize Your Cash Position
As the old saying goes, cash is king. A financially well-run business will have an improving cash position at the end of each and every month, says Victor Cheng, a CEO coach and author of the book, Extreme Revenue Growth. Said another way, a healthy company generates a positive cash flow, meaning the money coming in exceeds the funds flowing out the door. Keeping a running tally of your cash position over the past three months is a great way to see if your business is generating cash over a sustained period of time. 'It is pretty much impossible to go out of business if you are paying your bills on time and your bank account balance keeps growing each month,' says Cheng.
Cheng says that you want to look at a three-month trend because it will help you identify red flags. For example, if sales have increased 20 percent, but your cash position is rapidly declining, there's likely an issue with your accounts receivable. 'It means that there is a cash flow timing problem on those sales and it's incredibly risky for a business to do that, especially if they don't realize they are doing it,' he says. If, on the other hand, the cash position is improving but sales are declining, it means the company is making good improvement in internal operations, efficiency, and financial management - but the company has a serious external or market problem to solve.
Check Your Solvency
One way to check the financial health of your business is to calculate the following:
- Cash in Bank / Monthly Expenses = Number of Months Until Bankruptcy
This ratio shows you how many months your business can survive if sales suddenly stopped and none of your customers paid their bills that month, says Cheng. 'It is ratio I developed to freak out non-finance entrepreneurs so they will start paying much more attention to cash management and not just sales,' he says.
For example, Cheng says it is very possible for a business doing $1 million a year in revenue to double sales and go bankrupt in the process. Whether this happens or not depends on how quickly the cash is collected from customers and deposited in the bank relative to when you have to pay the bills for the increased expenses associated with the new revenue. 'If the entrepreneur has to increase expenses today, but collects that additional $1 million six months from now, they can very easily go bankrupt before they collect their money," Cheng says. "In cash management, timing is everything."
As such, another useful exercise is to chart your company's accounts receivable and accounts payable aged in thirty-day buckets, says Frank Stitely, a CPA in Chantilly, Virginia, who also pens the blog, 'How to Screw Up Your Small Business.' The accounts receivable numbers reveal the cash coming into the business and highlight any problems with old receivables, meaning money you have had trouble collecting from customers. The accounts payable numbers show the cash commitments of the business over the next thirty days to vendors. Since you're on the hook to pay your bills, any aging trend in the amount of money you're owed could spell trouble. 'When a business owner sees a quarter of accounts receivable over sixty days old, he or she should panic,' says Stitely.
Keep an Eye on Overhead Costs
While most business owners focus on growing revenues, they also need to keep an eye on how much they're spending on overhead (rent, salaries, etc.) to support those sales. A quick way to do that, says Cheng, is to calculate what percentage of your revenues are used to pay overhead:
- Overhead Expense Percentage (OEP) = Overhead Expenses / Sales
Cheng notes that the number by itself is not that useful. What makes it powerful is when you track it over a 12- to 24-month timeframe. Any fluctuation can reveal problems. 'If a company's sales drop 30 percent, but the OEP skyrockets, it means the company's overhead has stayed the same while sales dropped, and the company is taking on significant financial risk if they don't cut overhead to get the OEP back to it's historical level,' Cheng says. He further noted that many small businesses collapsed during the Great Recession because their owners failed to cut enough overhead to compensate for their loss in sales.
Look Beyond Your Financial Statements
Checking up on the health of your business requires more than just the numbers in your financial statements, says Dave Haviland, president of Phimation, a consulting company based in Ann Arbor, Michigan. 'Since financials are generally backward looking, they measure results,' he says. 'To look forward, you need to look at operational metrics.'
Haviland suggests tracking metrics in each area of your business. For instance:
- Marketing and sales: track the 'backlog' (work already signed but not yet billed/produced) and 'sales pipeline' (prospective work in the sales process). These are important because they give you a forward-looking view at what the revenue line will look like, says Haviland.
- Production: track your 'utilization,' which measures how efficiently your company is using its resources.
- Human Resources: By tracking 'suggestions and complaints' (such as notes put in a suggestion/complaint box) you can learn how engaged your employees are. Another suggestion is take a 'green/yellow/red' measure, where people put the color dot that represents how their day went. When you count up all the dots and track it over time, you can begin to get a sense of how productive your staff feels they are.
Haviland says you should prioritize what matters most to your business when coming up with other potentially helpful metrics, such as ones built around customer satisfaction and supplier performance.
Greg Alexander, CEO of Sales Benchmark Index, a sales consulting company based in Atlanta, advises tracking your New Business-to-Repeat Business ratio. This ratio tells you the revenue contribution from new prospects and the revenue contribution from existing clients. 'Healthy businesses depend on bringing in new clients as well as generating repeat business from existing clients,' says Alexander. 'However, if new business is outpacing existing business, you may have a customer retention problem. If business generated from existing clients is outpacing new business, you may have a marketing and sales problem.' Alexander says the right ratio for your company will depend on what kind of business you're in, noting that his is a 1:5, where repeat business outpaces new business by a five-to-one ratio.
While monitoring a daily dashboard is great for tactical adjustments, says Haviland, there are also monthly or quarterly metrics that can highlight more strategic changes in your business. Examples of metrics that tell you if you're staying relevant to the market (and which markets are best) include:
- Percentage of revenue from new products/services
- Revenue mix by product
- Revenue mix by customer segment
Again, the best way to keep on top of your company's financial picture – and to ensure that you sound the alarm before big trouble has already arrived - is to use a mix of current and long range metrics taken both from your financials as well as the operational side of your business.
By seeing how individual parts contribute to the whole, you'll be able to best identify where your business is stumbling. Once you've zeroed in the trouble spots, you'll have the chance to take the necessary steps to fix them.
Darren Dahl is a contributing editor at Inc. Magazine, which he has written for since 2004. He also works as a collaborative writer and editor and has partnered with several high-profile authors. Dahl lives in Asheville, NC.