If you’ve been in business for a while now, you’ve likely heard the mantra know your numbers. But if you aren’t a “numbers person,” do you know which numbers mean the most to your business — or what to do with that information, once you know them?
There are four financial-health indicators that many experts agree hold the key to running a viable, sustainable and profitable business: cash flow, profit, sales and gross margin/profit. And I suggest adding a fifth concept — allocation percentages.
Here is my veteran company bookkeeper’s take on how to make these healthy-business indicators useful and actionable in great economic times and in bad.
According to the U.S. Score Association, 82% of small businesses fail due to cash flow problem
1. Cash Flow
We all know cash is king, but I say cash flow must be queen. Simply put, cash flow is this: Is there more money coming into your business than goes out of it?
There’s a sobering statistic that says that, for most businesses, money has left the building! According to the U.S. Score Association, 82% of small businesses fail due to cash flow problems. This doesn’t mean those small businesses aren’t earning money, they just aren’t collecting it as fast as they spend it.
Even profitable businesses can run out of cash if they aren’t focused on cash flow. But the good news is, there are ways to optimize cash flow.
You can:
- Track your cash flow. It’s been said that what gets measured gets managed, and there’s a reason this business advice has withstood the test of time. That’s because tracking and acknowledging every dollar your business earns and spend is critical! (Our friends over at Xero accounting software offer helpful advice on tracking cash flow without spreadsheets.)
- Ask customers to pay you upfront. Consider collecting fees at the time of service or in advance instead of net 30 (or longer).
- Negotiate with your vendors. Ask suppliers if they can extend their terms so you can collect from your customers before you have to pay what you owe them.
- Save now and spend smarter later. Set aside money in a separate account for re-purchasing inventory, equipment upgrades, and other recurring expenses.
- Get creative with financing. Leverage debt, such as a low-interest line of credit, to bridge the time between sales and collections. Just make sure you factor the cost of carrying that debt into your pricing.
I recommend businesses save at least 10% of revenue as profit — that is, money the business doesn’t need to operate, pay loans, taxes or salaries, including owner’s pay.
2. Profit
After you pay your business’ bills, is there ever any money left at the end of the month?
If so, that’s great. But before you do a happy dance and think about what you could spend that surplus on, you could:
- Set the money aside — removing the temptation to spend it — for your tax bill, both sales tax, if applicable, and quarterly estimated income taxes.
- Pay yourself a fair wage or a regular paycheck for a change. (Some business owners I know don’t pay themselves anything. “I’m reinvesting in my business instead,” they say. And that’s not always wise.)
- Save the extra money in a separate bank account for company profit. I recommend businesses save at least 10% of revenue as profit — that is, money the business doesn’t need to operate, pay loans, taxes or salaries, including owner’s pay. If you’re thinking profit, what’s that? you could have a problem that’s masking other issues, such as reckless spending, labor inefficiencies, or poor pricing. (I’ll talk about more profit soon.)
If your business doesn’t have a trusted financial expert in its corner, ask around for recommendations.
3. Sales
If your overhead expenses are relatively steady, you should be able to figure out your minimum sales target number. Depending on your sales cycle (i.e., how long it takes you to sell and collect), you might need a monthly target or a weekly target. Someone with financial knowledge — a CFO, CPA, or an experienced bookkeeper — can help you determine that number.
If your business doesn’t have a trusted financial expert in its corner, ask fellow business owners or your broader network, including vendors, for recommendations. Make sure you know what kind of relationship you want (i.e., the services you need, price range, response time, etc.). Find someone who will answer your questions in a timely manner, in a way you can understand what they say and someone you will actually enjoy talking to over the months and years to come.
It can help to calculate a break-even price for goods and services to know the price at which you are actually losing money with each sale.
4. Gross Margin/Profit
If your business is making lots of sales but not making enough profit, you may be pricing your products and services incorrectly. And that, pardon the pun, is a gross mistake that needs your immediate attention!
Pay attention to gross margin — the difference between what you sell something for and what it costs you to sell it. Many business owners don’t factor in every cost associated with the sale of their products and services. You need to be able to cover not only all purchasing or producing costs but also expenses associated with business overhead, taxes, salary, growth, and (I’ll say it again) profit.
It can help to calculate a break-even price for goods and services to know the price at which you are actually losing money with each sale. Again, a trusted business advisor can help you calculate your gross margin, break-even numbers, and the point of profitability.
Focus on cash flow, profit, sales, gross margin/profit, and allocation percentages, and you’ll be in a better position to know the numbers that power your business.
5. Allocation Percentages
Here’s where my fifth addition comes in, the allocation percentages.
Mike Michalowicz, in his book Profit First, talks about tracking your expenses by the percentage of total income (the allocations), rather than just tracking the dollar amount. That way, regardless of any fluctuation in business’ income, you can still be on target to meet your financial obligations.
Adhering to these allocation percentages helps you save the appropriate amount for taxes, as a percentage of income, know that you’re paying yourself a sustainable amount without stressing the business, and put aside a set percentage of income for your future.
If you’re interested in learning more about allocation percentages and the Profit First cash flow approach, you can download the first two chapters of the book here.
Knowledge is Power
When you focus on this fab financial five — cash flow, profit, sales, gross margin/profit, and allocation percentages — you’ll be in a better position to know the numbers that power your business. And that’s a powerful thing!
This article was originally published on Insightful Accountant, an independent news and information source written specifically for the small business advisor who needs to stay current on the latest news and offerings in accounting technology.