Running a Business

3 Key Questions Small Business Owners Must Answer, or Risk Failure

3 Key Questions Small Business Owners Must Answer, or Risk Failure
Image credit: Startup Stock Photos

Whether you’re running a pole-dancing fitness business or an online Etsy store, all your management efforts and sleepless nights really come down to three crucial questions about your business -- and the three crucial documents that help you answer them:

Related: How Long Do You Really Need to Keep Your Financial Documents?

1. Are you making a profit? (Consult your net income statement.)

Profits are measured in one place: your net income statement. "Net revenue," which is usually the same thing as net sales, doesn’t give the whole story because it doesn’t account for all the direct and indirect expenses needed to run your business. For example: If you’ve paid bills lately, you know that rent, utilities, insurance, accounting fees, web and tech-support all cost money. So, profit is what you have after you deduct expenses from net sales. 

That calculation creates your business's net income number. Is it positive this month? Then you’re making money. Good deal. But did you know you could be showing a profit and still be going bankrupt? Knowing whether you’re making money is not enough; that money has to convert to cash.

2. What's your cash situation? (Consult your cash-flow statement.)

Cash is the lifeblood of your business. In a perfect world you pay bills with cash generated from operations -- not debt, if you want to maintain fiscal sanity. To pay with cash, your small business has to kick off enough of it to cover the bills. Do you have enough cash to cover expenses for at least 90 days? You’ll find out by looking at your cash-flow statement.

Remember, cash is to your business as blood is to your body; without it, your business dies. Cash comes in when clients pay you. But sometimes they don’t pay full retail price because of discounts or third parties like PayPal that take a percentage of the transaction. Just because you charge X doesn’t mean you’ll collect X when you make a sale. Sometimes, too, there’s a time lag between when you complete a project and when you get paid. This is common in some service businesses, but it needs to be carefully managed; otherwise, you’ll merely have an expensive hobby, not a business. 

Related: How to Better Manage Your Cash Flow

3. Are you building or destroying wealth? (Consult your balance sheet.)

Building terminal value is why you’re in business. Terminal value is what you could sell the business for if you decided to do so today. If you’re a small business owner, what’s the long game? Is it just about grinding through 12-to-16-hour days for decades only to retire when the doctor tells you to? Or is it about emulating the sharks on ABC’s Shark Tank who got to be so wealthy?

They built businesses that grew assets faster than liabilities -- a lot faster. In some cases they sold their businesses; in others they used the business as collateral to attract venture or seed money for new ventures. It’s an amazing system when it works. So, how about your business?

Do you have a small business you could sell eventually? Your balance sheet is crucial here. It measures your assets, liabilities and owner’s equity, or net worth of the business. It’s not the only measure of value, but it holds valuable information every banker and investor wants to know. It’s the first step in determining terminal value.

Do you know how to read your net income statement, cash-flow statement and balance sheet? In my 20 years in business, I've seen how clear it is that if you don’t understand these documents, you’re leaving tremendous profit and cash-flow potential on the table. Your small business is also probably carrying far more risk of failure than you know.

Would you drive your car with your eyes closed? No way, right? So don’t run your small business without knowing how to answer these three key questions. Finding the answers is easier than you imagine. And those answers can change your future. 

Related: The Ins and Outs of Cash-flow Statements