As any successful business owner can attest, keeping a company on track requires constant analysis: assessing your strengths and weaknesses, understanding your financial position and evaluating the risks you may be taking.
While keeping tabs on the financial health of your business might seem daunting, doing a regular checkup isn't as complicated as it sounds. Some basic ratio analysis will help you check your business's temperature, identify potential problems, and see if your company is on the road to financial freedom or a cash-flow crisis.
And because cash flow is the single most important factor in managing a profitable business, measuring liquidity is absolutely essential. "You have to constantly know what your current ratio is--your assets divided by your liabilities--and as long as your number is one or above, at least you're afloat," says Tom Bayer, partner in Sikich LLP, an accounting and business consulting firm in Springfield, Illinois. He suggests reviewing your income statement and your balance sheet monthly and assessing your projected cash flow report monthly, or even weekly, depending on how tight cash flow is.
But cash-flow analysis is just a start. "You've [also] got to manage your receivables and inventory," says Bayer. To determine how well you're managing receivables, calculate weekly the average number of days of receivables outstanding, which is the average number of days it takes to collect receivables (accounts receivable divided by sales, multiplied by 365 days). Meanwhile, calculate monthly the inventory days ratio--also known as the days-to-sale figure--which measures the number of days you're holding your inventory (inventory balance divided by the cost of goods sold, multiplied by 365 days).
As your customer base grows, it's important to determine which clients are actually worth having. "Every year, a business should step back and say, 'Who's not profitable for me?'" Bayer urges. "Your worst customers could be those who absorb a lot of your time because they complain and then don't pay you timely. [By firing them], you can focus on your best customers and provide them more products and services."
However, if your slowest payers are also your best customers, consider offering a discount to entice them to pay earlier. By the same token, how well you manage your own cash outflow will determine whether you're getting maximum benefits from each dollar you bring in. Conventional wisdom suggests that you should pay your bills on time but never before they're due. Taking advantage of a trade discount is one exception, meaning that some suppliers may offer a discount if you pay within a specified period of time. If what you earn by taking advantage of the discount is greater than what it costs you in borrowing expenses, then the discount is worth taking.
Rx for Success
"From a financial standpoint, there are two things that you always want to concentrate on as a business," says Tom Bayer, partner at Sikich LLP, an accounting and business consulting firm in Springfield, Illinois. "The immediate is cash flow--managing and monitoring [it]--and the other is creating something of value in terms of your business." Giving your business regular financial checkups will help ensure that you achieve both objectives, says Bayer. His advice:
- Take your fiscal temperature with financial ratios. They can help chart your company's progress, uncover trends and point to potential problems.
- Fire your worst customers. Whether they're slow payers or chronic complainers, getting rid of them will allow you to focus on serving--and attracting--more profitable clients.
- Ask yourself if your sales are too much of a good thing. While you need increased sales for growth, extra inventory and outstanding receivables can stretch cash flow to the breaking point.