Business is a numbers game. If you don’t believe it, listen in on one of the conference calls that publicly traded corporations host after each quarterly earnings release. You’ll hear Wall Street analysts and money managers grilling corporate managers on a host of financial metrics crucial to understanding the company’s health and growth prospects.
Most small-business owners don’t have the time or staff to track all these esoteric metrics that big companies follow. But every entrepreneur can profit from tracking a few key financial measures that could warn if their company is headed in the wrong direction.
Some are simple enough for a layman to calculate. Others might require an accountant’s help in performing the initial analysis.
The break-even point
One of the easiest ways to keep tabs on your company’s health is to know your break-even point, says certified public accountant John Sauder, entrepreneurial business services partner with Clifton Gunderson LLP in Peoria, Illinois.
A break-even analysis shows how much business you must do just to cover expenses. A manufacturer may translate that into how many widgets it must sell, a physician into how many patients she must see. The math becomes increasingly complicated the more complex the enterprise, but Harold Averkamp, a CPA and former accounting instructor at the University of Wisconsin-Whitewater, provides an easy-to-follow example at his AccountingCoach website. You can find it here.
Once you’ve calculated your break-even point, you only need to update it when there’s a significant change in your costs or product offerings. In the meantime, you can tell just by glancing at weekly or monthly sales figures whether your company is generating enough business to keep its head above water.
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The acid test
Dan Morris, CPA and principal with the firm of Morris + D’Angelo in San Jose, California, suggests you perform a periodic “acid test” to assess your company’s fiscal health. This test measures whether you have sufficient short-term assets to cover short-term liabilities without selling inventory. The traditional formula adds cash, accounts receivable and short-term investments, then divides by current liabilities. A figure below one indicates trouble: The company doesn’t have the resources to pay its bills.
Morris customizes this metric for his clients and pairs it with a traffic-signal analogy. For a typical business, he adds cash to collectible receivables plus available short-term credit, then divides the result by current accounts payable and the company’s next payroll.
If the result is less than one, the indicator is red: The company doesn’t have enough resources to meet its current obligations. If the figure is above 1.5, the indicator is green: Everything is good to go. If the number is between 0 and 1.5, the indicator is yellow: The company is able to meet its current commitments, but with little cushion.
Companies in the red or yellow zones, Morris says, should calculate this number daily. Those in the green can do it weekly.
Set up a dashboard
Morris recommends creating a dashboard of such indicators to show you at a glance how your company is performing. Off-the-shelf software can make a dashboard for you by pulling data from accounting packages such as QuickBooks, or you can create one manually in a spreadsheet.
Potential metrics to feature, in addition to those already cited, include the amount of cash your company has on hand, the value of your accounts receivables, the available balance on your bank line of credit, and perhaps the value of your inventory relative to trailing 12-month sales. If inventory is growing faster than sales, Morris says, it can signal that too much cash is tied up in your warehouse.
There are, of course, a host of other financial metrics that you may want to monitor on a regular basis. Your accountant can help you decide which are appropriate for your business. Likely candidates include cash flow and your debt-service coverage ratio.
While there are sophisticated definitions of cash flow, many small businesses can make do simply by comparing how much money comes in the door from customers each month with how much is going out for materials, salaries, rent and other overhead expenses. If the number is negative or trending lower, find out why. “What you want to know is, are you going to run out of money,” Morris says.
Your debt-service coverage ratio measures your ability to pay off debts. The standard calculation is net operating income divided by total debt service. Banks typically like to see a figure of 1.5 to 2.0, Morris says. If this number is trending down, find out why. Below 1.0, it’s crisis time: You’re not bringing in enough money to cover your debts.
Financial metrics are guideposts to your company’s health. Monitoring them regularly can help you identify and correct problems before they become insurmountable.
A former reporter and editor for Dow Jones, where he wrote for the Wall Street Journal and Barron’s, Randy Myers is a contributing editor for CFO, Corporate Board Member and Plansponsor magazines.
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