It is common for new entrepreneurs and even experienced small business owners to operate their companies without clearly using financial tracking or safeguards. The typical results are usually hemorrhaging of cash through uncontrolled expenses, operating at a financial loss and even bankruptcy or closure of the business.
However, you can prevent these drastic results. While not every entrepreneur is an expert on small business finances, it is critical to be aware of and familiar with important small business financial statements, ratios and terms so as to keep the business running profitably.
Below are helpful categories of financial elements such as statements, ratios and even terms that will help you determine which numbers are critical, why they are important to identify and how you can leverage them to improve your small business finances.
Important Financial Terms
You don't need an MBA or be an expert in financial analysis to control your small business finances. But you do need to know important terms that are part of your daily and week-to-week financial reviews. Here are a few important terms:
Net Income - This number is the money you earned (or lost) after tallying up everything you brought in (revenue) and subtracting everything you spent (expenses). Hopefully this "bottom line" number is always positive, giving your business hope for continued prosperity and growth.
Gross Margin - This tells you how much money you have left over after you tally up just the direct expenses related to the actual manufacturing, production and selling of your product. Direct expenses might include labor, wholesale cost of your goods, packaging, etc. You want this number to be as high as possible because you still haven't subtracted your general or overhead expenses.
Cash Flow - Also an important number you want in the positive range. This tells you where your cash is coming from (sales revenues, A/R, loans, etc) and where it goes and how much is left over each month.
Financial Ratios - This term refers to the calculation of certain percentages using important numbers from financial statements. More on this below.
EBIT - Earnings Before Interest and Taxes. This is near your bottom line and it is a better way to show your profit before you calculate your taxes and interest payments due.
Know Your Basic Financial Statements
Sound small business finances depend on important financial statements. Here are a few you will likely use:
Balance Sheet - This worksheet tallies up all your assets and subtracts all your liabilities. What is left is your equity in the company. Often the balance sheet equation is noted as Assets = Liabilities + Equity. This statement can be created at any time and shows a "snapshot" look of your current financial situation.
Income Statement - This statement is often created at the end of a period like every month or quarter. It adds up all your sales and other revenue and it subtracts your expenses to give you a net income for the period.
Cash Flow Statement - This small business financial statement is also periodical and shows where cash came from and where it went. This statement can also be created "pro forma", or before the fact to help you plan on projected cash shortages.
Knowing Key Financial Ratios
Financial ratios are used to give you a more simplified number that is based on relation. For instance, say you calculated your Current Ratio (noted below) to be 1.25. That means for every dollar you owe, you have $1.25 in liquefiable assets to cover it. In relation, you find that most companies in your industry operate successfully at a 1.5 current ratio. This helps you know that you need to improve your assets or reduce your liabilities.
Here are some important ratios:
Current Ratio - Take all your current liabilities (amounts due within 30 days) and divide that total by your current assets (assets that could be liquid within 30 days). (Current Assets / Current Liabilities).
Acid Test - A more "liquid" test. Divide your current liabilities into just your cash available. (Current Cash + other Liquidity / Current Liabilities)
Inventory Turnover - How quickly do you go through your inventory? Do you end up having too much in stock? Or perhaps too little? This ratio shows how many times is sold and replaced during a specific period. For each completed financial period, take your inventory total and divide by your sales. (Sales / Inventory, or also calculated Cost of Goods Sold / Average Inventory)