Evaluating The Financial Health Of Your Small Business

Evaluating The Financial Health Of Your Small Business

When you run a small business, it’s easy to get the feeling that you are a first responder who is constantly on the front lines. There may even be times when it may seem as though one fire is barely under control before another conflagration starts. In the midst of all of this craziness, however, it is vital that you also assume the role of your company’s primary care physician who regularly assesses the financial well-being of your operation. 

Examine The Building Blocks Of Your Accounting System

It is impossible to gauge the viability of your finances if you don’t have organized, clear records of income and expenses. All too many small business owners are so wrapped up in the crisis of the day that they simply throw receipts into a drawer, telling themselves that they will come up with a better system “when things settle down.” The problem is, that never happens, and tax time ultimately becomes a nightmare.

Your top priority is to first get all of these scattered pieces of data in hand and then to adopt an automated small business payment processing and accounting system. This solution will give you a stable and easy-to-use structure that will allow you to immediately input all transactions as they occur. In addition, you will have the tools to generate all manner of reports that track inventory, sales trends, and payroll. Best of all, you can diagnose the symptoms of future financial difficulties before they become full-blown catastrophes.

Assess Your Liquidity

No matter how good your small business payment processing software may be, you still need to have access to cash to cover debts or emergencies. When you apply for a short-term business loan, liquidity is one of the major factors that lenders will consider.

To measure it, they use several ratios. The two most important ones are your current ratio and your quick ratio. The current ratio is x:y, where x is your current assets and y, is your current liabilities. For example, if your assets on hand amount to $40,000 and your liabilities are $20,000, your current ratio is 2:1. A current ratio of 2:1 or higher is desirable; if yours is lower (such as 1:4), you may want to apply for a long-term loan that will enable you to pay down some of your debt.

Your quick ratio, also sometimes called an “acid test”, is your current assets minus inventory (x) compared to your current liabilities (y) For example, if your assets minus inventory are $50,000 and your liabilities are $25,000, your quick ratio would be 2:1. Anything above 1:1 is desirable. If you find that your liabilities exceed your assets after subtracting inventory, immediately take steps to change this situation. As in the above example, you could apply for a long-term loan. Another solution is to sell off some of your inventory without replacing it, using the proceeds to pay down your debt.

Examine Your Profit And Loss Statement

Your business’s income statement is a gold mine of information that you should use to your advantage. Generally, it will contain data from the past three years that covers such vital areas as sales growth, expenses, and annual trends. The top line is your gross revenue, and the bottom line is the amount of money that remains after all income and expenses are calculated at the end of the specified period. As you can imagine, this information is crucial if you are to evaluate your business’s financial well-being. If it is erroneous or incomplete, the results will be unreliable.

Monitoring sales patterns is perhaps the best gift that your profit and loss statement can impart since it gives you the ability to view how your business has done over time. To get a true sense of your financial viability, calculate your gross profits over the three years of your profit and loss statement by dividing your net income by your gross profit for each year. Ideally, the percentages that you see should remain steady or increase. Take action if you see a downward trend.

If your fortunes appear to be slipping, don’t lose hope. There are several steps you can take to nudge things in a better direction:

  • Cancel contracts that are not benefiting your business;
  • Boost sales by embarking on a free or low-cost social media marketing campaign;
  • Find inexpensive ways to outsource;
  • Ask vendors if they can reduce your rates.

Anything you can do to lower costs while increasing sales can help to buoy your next income statement.

Keep A Balanced Inventory

You need to walk a fine line between having too much product in hand and not enough. If your inventory is insufficient, customers will be unhappy when they are unable to get what they want. On the other hand, over-stocking can tie up your capital.

To get a handle on your status when it comes to inventory, calculating two ratios can be particularly helpful:

  • Figure out the average inventory investment period by dividing your present inventory balance by your average daily cost of goods sold. Divide the remaining inventory balance at the end of this same time period by this number to obtain the number of days it took to convert your original expenditure on the inventory into sales.
  • Obtain your inventory-to-sales ratio, a figure that reflects recent sales. In this ratio, x is your monthly inventory balance and y is your sales. Monitoring this number over time can give you insight as to sales trends and can help you decide whether you should reduce or increase inventory or take intentional steps to elevate sales.

Assess Your Debt 

Understanding your debt load is essential in gauging your company’s financial standing and determining if you need to make changes or corrections. Monitoring your debt-to-equity and debt-to-assets ratios can be very helpful.

Your debt-to-equity ratio is determined by comparing the amount your company owes to your equity. For example, if you owe $100,000 and have an equity of $50,000, your ratio is 2:1. The lower this ratio is, the better. 

Your debt-to-assets ratio is determined by comparing what you owe against your assets. For example, if you owe $100,000 and have total assets of $50,000, your ratio will be 2:1. If your ratio is below this amount, you might have a difficult time paying off any bills that might arise.

Just as it is important to enhance your length and quality of life by keeping an eye on benchmarks such as blood pressure and cholesterol levels, the successful entrepreneur must keep a finger on the financial pulse of their company. Make it a point to put your business through this evaluation on a quarterly basis – no matter what current fires are brewing – to ensure that you can pinpoint issues as they arise, addressing them immediately. This consistent investment of attention will reward you time and time again in the long run.