By Jean Kruse / Guest Editorial
Anyone who longs for the “good old days” probably doesn’t own a small business. Given the variety of powerful, easy-to-use accounting software products available today, it’s difficult to imagine wanting to keep records and prepare financial statements by hand.
But while technology has eliminated the need for stubby pencils and green eyeshades, it’s still up to the small business owners to analyze and understand the meaning of their financials in order to make wise decisions.
While there’s no hard-and-fast rule for reviewing financial data, most experts recommend a minimum of monthly or quarterly evaluations. For some businesses, it’s advised to evaluate financials more often; managers of restaurants, for example, are advised to evaluate their costs in relation to their sales on a weekly basis. Otherwise, you risk spotting serious problems too late to take corrective action.
You should set up your accounting software to print comparative financial statements, comparing a period from this year with the same period of the prior year. For example, compare the profit and loss statement for the month of October and the year-to-date ending Oct. 31 for both years, and do that for each month.
In addition, set up a “percent of sales” column for both the month and the year-to-date so you can compare outcomes by the percentages. A sudden difference in the percentages of key expenses may signal issues that need to be addressed.
Cash flow is a key indicator to watch. This is the revenue coming into your business balanced against expenses (rent, payroll, supplies etc.). Projecting cash flow into the future will help alert you to potential bottlenecks in meeting payment obligations, and whether changes in your collection strategy or operating budget are warranted.
One way to do this would be to use a cash flow projection template, which can be found on the SCORE national website (www.score.org). The Excel template allows business owners to estimate monthly income, expenses and other obligations by month. If the bottom line of the spreadsheet results in a negative number for any month, the owner will know when there may be a cash flow problem. This is a useful planning tool that allows you to realize when to cut back or delay purchasing, or when a bank loan will be necessary. Some accounting software can also do the cash flow projections for you.
Several financial ratios can also help small business owners gauge the health and progress of their enterprise. Because these ratios fluctuate over time, tracking them will help you spot trends that could evolve into opportunities or problems. The ideal average of all of the financial ratios discussed in this article can best be learned from the trade association for the particular industry. In addition, there are several online sources to determine the best financial ratios for any particular business, including www.bizstats.com and http://bit.ly/bizratios. Business owners should become familiar with the financial ratios that pertain to their type of business.
Liquidity ratios measure the firm’s ability to meet short-term commitments from its liquid assets. The current ratio (current assets divided by current liabilities) is a simple measure of a firm’s ability to meet short-term obligations. Similarly, the quick ratio (current assets minus inventory divided by current liabilities) measures the firm’s ability to meet short-term obligations from its most liquid assets. The ideal average for both varies from one industry to another.
Leverage ratios indicate the company’s ability to meet both long- and short-term obligations, making them particularly important to bankers and investors. The most frequently used indicator is the debt ratio (total debt divided by total assets). Generally, lenders want this ratio to be as low as possible.
Profitability ratios measure how well a company earns a net return on sales or investments. Gross profit (gross profits divided by net sales) measures the margin on sales – essentially the overall effectiveness of the business. Net profitability (net income divided by net sales) shows the effectiveness of management in controlling costs.
Then there are activity ratios, which show how well a company uses its assets to generate sales. Small businesses that manufacture or sell products should monitor inventory turnover (cost of goods sold divided by average inventory), while businesses of all types should watch their average collection period (average accounts receivable divided by average credit sales per day) to determine if they are being paid promptly.
Need more help navigating your small business financial numbers? You’ll find plenty of guidance at SCORE. Free and confidential mentoring is available by clicking on “Request a Meeting” on our website, www.scorecr.org.
Jean Kruse is a SCORE counselor and SCORE Iowa district president. She operated her own CPA firm for 13 years and in 1988, joined RSM McGladrey, a national firm, where she provided accounting and tax services to small businesses.