Working with a great accountant is an asset; leaning too hard on one can be a flaw. Here are key steps to boosting financial literacy and keeping a simple guide to profitability.
Business owners have a tendency to rely heavily on their accountants when it comes to tracking their company's critical numbers. Having a strong relationship with a reliable CPA is certainly a must for any business, but you can never forget as a business owner that responsibility for the financial health of your company rests ultimately with you and you alone. If you're someone who is a bit intimidated by accounting, just stay with us—we wrote this guide with you in mind.
The simple truth is that you don't need an MBA or an in-depth understanding of double-entry accounting to know which numbers are the most critical to the health of your business and deserve your keen attention, says Ellen Rohr, founder of Bare Bones Biz, a business consultancy based in Springfield, Missouri. "As a business owner, you need to get over your fears and quit talking about how nobody taught you how to understand the numbers," says Rohr, who also authored Where Did the Money Go?, a primer text for small business owners interested in improving financial literacy. "The information is out there. It's up to you to go find it."
Dig Deeper: Critical Numbers You Should Follow
Tracking Your Critical Numbers: Start with the Basics
As we get started, let's do a review of the basic financial documents that track the flow of money within your company. Most critical numbers live on these documents.
Balance Sheet: This is a cumulative document that lists your company's assets and liabilities, among other numbers, from the time you started your business. Reviewing your balance sheet gives you a quick handle on the financial strength and capabilities of your business.
Income Statement: Also known as the profit and loss statement, or P&L, or statement of operations, this document lists your company's income (revenues or sales), minus your company's expenses, and it shows you the profit or loss over a specific period of time.
Cash Flow Statement: A cash flow statement helps you stay on top of how much money came and went through the business for any period of time. This document is critical because it helps you understand why, even if your company appears to be turning a profit, you don't have much money in the bank.
Dig Deeper: Helpful Profit-Tracking Worksheets
Tracking Your Critical Numbers: Focus on Key Profitability Terms
The term profits should be relatively self-explanatory. The rub is that there are several terms that represent the profitability of your business and keeping them straight can be confusing. Here's a primer on understanding critical profit numbers:
Gross Margin: Also called gross profit. This is how much money you have left after you have subtracted the direct costs from the selling price of your product or service: income minus direct costs equals gross margin. The higher your margin the better, because you need to have enough left over to pay your indirect costs or overhead (things like salaries, rent, advertising, telephone, and utilities) and still make money. If you don't, then you are likely not charging enough for your products or services.
Net Income: Also commonly referred to as net profit, net earnings, current earnings or the bottom line. You arrive at this number by subtracting all the expenses in your business, including taxes, from your revenue. This number is critical in that it reveals how much money is left after accounting for business operations. If the number is negative, well, then you're company is not profitable and has in effect produced a loss.
EBITDA:This acronym stands for earnings before interest, taxes, depreciation and amortization, which essentially is a way to make profits look better than in comparison with net income. Ebitda is widely used as a way to report earnings for a company, but it can be deceptively optimistic in that it doesn't take into account taxes and interest payments.
Dig Deeper: Inc.com's Guide to Tracking Gross Margin and Income
Tracking Your Critical Numbers: Learn Some Key Ratios and Create a Number Dashboard
Now that you have a handle on these critical numbers, and how to calculate them, you can then begin to use ratios to understand the health of your business. Ratios help you to understand how these numbers work together. For example, a company's current ratio tracks the relationship between assets and liabilities. Following ratios over time will help you to understand the momentum in your business. Are assets increasing vis a vis liabilities?
To keep tabs on these critical numbers and ratios, Rohr suggests you create a dashboard that draws information five or six key numbers from your financial statements on a weekly basis, and helps you monitor the health of your company. Here are the numbers Rohr suggests you track most closely:
Sales/Revenues: Everyone tracks sales, Rohr notes. The mistake most executives make, however, is that they only compare contemporary numbers with those of past time periods. Comparing figures to what you want them to be in the future is a better way to go, Rohr says. In other words, your objective should not be to see how far you've come in the past year—it should be to track your progress against where you hope to be in the coming year.
Net Profit: Profits fix just about everything, Rohr says. "As long as you are charging more than it costs for stuff, you can ensure that you'll continue to grow your company soundly," she says. "If you don't have profits, then everything else is a cheap trick."
Defensive Numbers: This refers to Gross wages as a percentage of sales and overhead as a percentage of sales. Rohr recommends that you watch two simple ratios with an eye toward fluctuations. If the percentages rise, then they should serve as an alarm bell to investigate why overhead or wages are going up, why sales are going or some combination of all of the above.
Quick Ratio: The formula for this should be cash plus accounts receivable divided by accounts payable, or current liabilities. Rohr says this is an important number to stay on top of because it tells an owner how much cash he or she has one hand to deal with their bills. You should be looking at a bare minimum of a one-to-one ratio here since that tells you that you have enough cash on hand to pay your bills. If you want to breathe easier or sleep better at night, you want even want to target a ratio of two-to-one, Rohr says. But, if you have too big of a number stuck in your accounts receivable, meaning you don't have the cash yet, that gives you an action item to tackle. "Money that stays too long in A/R is a disaster waiting to happen," Rohr says.
Total Inventory: Rohr says that if your company keeps an inventory, it's important to monitor it on a weekly basis because "if that number starts to creep up each week, you might be in trouble."
Debt-to-Equity: If your business has debt, it belongs on your quick check sheet. The point is to know what your ratio should be and whether you want to establish a budget to begin paring down your debt level.
Dig Deeper: A Sample Ratio Worksheet
Tracking Your Critical Numbers: Other Critical Numbers
Those numbers most critical to your business can also be very specific to the industry you operate in. A software consultant may focus on billable time, for instance, while a food retailer should be looking at sales per labor hour. For some ideas about other potential figures to add to your critical number checklist, click here and here.
Dig Deeper: Critical Numbers in Action
Tracking Your Critical Numbers: Additional Resources
A Beginners' Guide to Financial Statements.
A resource provided by the Securities and Exchange Commission that breaks down the key terms and concepts found on corporate financial statements.
The Edgar Online Guide to Decoding Financial Statements by Tom Taulli. J. Ross Publishing, 2004.
This book should appeal to the more detail-oriented reader as it focuses on breaking down each and financial metric in a given business from an investor's perspective.
The Great Game of Business by Jack Stack with Bo Burlingham. Doubleday, 1992.
The book that arguably helped launched the open-book management movement, The Great Game teaches owners and employees alike to think of the numbers behind their business as a game. Stack also discusses identifying the critical numbers in any business as well as how to create incentive programs to get the whole company thinking about 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.