The Critical Numbers You Need to Know for Business Success (Part 1 of 2)
By: Andrew J.Sherman
Partner, M&A and Corporate Department, Jones Day
JUNE 03, 2014
Your forte may not be accounting or financial management, but if you want your company to thrive, you should monitor and review these key business numbers.
Most small-business owners don’t have financial or accounting backgrounds, yet they rely on a few critical numbers to help their companies survive and thrive. They’d rather make a terrific product or provide outstanding customer service than have to review their financial statements or analyze their company’s financial reports.
But while your company may still be too small for you to hire a full-time CFO to manage the financial aspects, knowing your numbers is a necessary evil that comes with owning your own business.
The ABCs of Financial Management
Do you know your hypercritical numbers? Do you understand which figures and accounting principles are most important for the stability of your business? Here are some essential terms you’ll need to understand before we dive into the key numbers you should be keeping an eye on:
• Balance sheet. A summary of your business’s assets and liabilities at a specific point in time. It’s also referred to as a statement of financial condition.
• Income statement. A report that summarizes your revenue, or gross income, minus the cost of goods sold to determine your gross profit. It’s also known as the profit and loss statement or P&L.
• Equity. The money or property invested and retained in your business by the owners and/or shareholders.
• Debt. Any loans taken by your business that must be repaid, usually with interest, over a period of time.
• Accounts receivable. The money your company is owed from sales of your products or services.
• Accounts payable. The money you owe to vendors and suppliers.
• Cash flow statements. A report that summarizes how much cash is going in and out of your business during a specific period of time. The statement is determined by analyzing operations, financing activities and investing activities to calculate your current cash on hand and predict future amounts. One of my personal favorite ways to generate numbers for a cash flow statement is the “quick ratio” or “acid test,” which works by measuring cash and accounts receivable divided by accounts payable (or current liabilities). A ratio of 2:1 or better usually means that you have effective cash flow management processes in place.
Why It’s Critical to Understand Your Numbers
As the owner of a small company, you’ll probably be the “chief cook and bottle washer” when it comes to accounting, financial management, budgeting and forecasting, at least for now. When you wear all those hats, you must be intimately familiar with the “blind spots” that could affect the viability of your business.
Every industry has a financial Achilles heel that, if not carefully managed and monitored, can cripple your company. For example, in the restaurant business, it may be your food and labor costs as a percentage of sales. In the retail industry, it may be rental charges or costs per square foot. In a consulting service, it may be revenues per professional. In manufacturing, it may be inventory turnover or percentage of defective returns.
No matter what your business is, you need to know your critical numbers, then build a dashboard to monitor them carefully and compare them to key industry ratios. So, for example, if your food costs as a percentage of sales are 41 percent and the industry average for a restaurant of your type and size is 28 percent, then that’s a red flag that something is very, very wrong. Your dashboard or scorecard will provide these yellow or even red warning lights that tell you when proactive remedial action is needed.
As it relates to the financial operations of a small business, the profit and loss statement tells the most important story as to how your business is performing. This is where the results of your company’s efforts and successes are most often expressed. As a result, many small-business owners won’t focus as intently on their balance sheet and what story it’s telling.
But that’s a big mistake—you should be intimately aware of the details of your balance sheet and its relevance to your business’s ability to execute on its business and growth plan. Drivers in this equation include items in your company’s operating cash cycle, such as investments in inventory, accounts receivable and other assets, offset by the amount of terms extended on payables. You should also understand how much every new dollar in sales requires in investment in additional working capital.
The fact of the matter is, all small companies will inevitably encounter financial or cash flow problems—it’s not an if but a when. Having the right systems and business processes in place so your company has reasonable visibility and has the information available to help you make informed decisions when there’s a problem is of paramount importance. The size and complexity of your business will usually dictate the types of business intelligence systems you’ll need, but a process and a reasonable system for analyzing information is necessary even for a smaller, less complex enterprise.
There’s an old saying that “We manage what we measure.” Even owners of small businesses need to act “CFO like” when it comes to developing internal financial reports and dashboards. Get into the habit of producing reports, then reviewing the results by yourself and with your board of directors or advisory board, and the key leaders of your team to the extent that you’re comfortable sharing financial information. Consider establishing a relationship with a coach, mentor or consultant with whom you can discuss your key numbers with candor and confidentiality.Continue Reading Part 2 of 2
“Do you know your numbers? Knowing your numbers starts with knowing and understanding how the numbers are generated”.