Financial Management 201: Determining the Health of Your Business—Beyond the Basics
A lot of business owners look to the Balance Sheet to determine their financial condition. Many of them look at one number: the cash balance.
Wrong number. Sorry.
Yes, yes, I know…. “Cash is King”, and all that. And I’m not arguing that cash isn’t the grease that makes the wheels turn. It absolutely does. But the cash balance on your balance sheet isn’t the best barometer of your business’ overall health and prosperity.
For one thing, by the time it hits your desk, that number is out-of-date. That number is the cash balance as of the last accounting period. A lot of cash transactions have happened since then. Nor does it reflect the claims on that cash. Is payroll due to hit tomorrow? What about that big outstanding payment to your largest vendor? Your operating loan installment?
If you are concerned about how you are going to meet your cash obligations, ask your Controller/CFO to prepare a cash forecast on a weekly or bi-weekly rolling basis. This document will show you if you are going to keep your head above water from a cash standpoint. But this still isn’t enough information to know if your business is healthy.
You wouldn’t want your doctor making that determination solely on your body temperature, would you? There are many measurements that help a physician determine your physical state of health; as a business owner, you should look at several measurements as well.
Your financial reports should be prepared on a comparison basis. You should be able to see at a glance, how each number compares with its counterpart for the same period last year. Are your revenues and expenses trending up or down? What is the reason behind the trends? How much liquidity do you have locked up in inventory?
Net income is an important parameter but be aware that if you are paying yourself above market rent on the business real estate, or paying personal expenses out of the business checking, your net income number is likely understated. (Yes, I know these practices are not ok, but let’s be honest. It happens.)
You should also be keeping tabs on your accounts receivable aging, your accounts payable, and your budget-to-actual performance. But we need to be taking it even a step further.
The key word here is ratios. Financial ratios are used to perform quantitative analysis on the information contained in the financial statements, bringing context and greater meaning to the reported information. Ratios are grouped into 5 categories: liquidity, leverage, efficiency, profitability, and market value. Not all ratios are appropriate for your business; you should work with your controller/CFO to determine which ones are most useful to you. And you should request these ratios be prepared for you on a monthly basis, as compared to standard ratios for your industry.
At Alliance ProAdvisors, we prepare your monthly financials, and we can help you understand them, too. Our CFO services are expert in forecasting & ratio analysis. We are happy to help you assess the health of your business and answer any questions you may have. Give us a call.
Kate