I don’t think I’m alone when I suggest, that like many small business owners, I didn’t jump into business ownership because I was really excited about small business bookkeeping or accounting. I knew it was part of the deal, but it wasn’t the part of business ownership I was the most jazzed about. Nevertheless, there are important small business financial metrics every business owner needs to know.
Despite the fact that one of my best friends is a CPA and was regularly offering me accounting advice (some of which I actually listened to), like many business owners I know, I thought I had a better handle on the important small business financial metrics than I really did. Looking back, I recognize that with a better understanding of what I didn’t know at the time, my life would probably have been easier.
Understanding your business’ financial metrics, and what those numbers are telling you, is critical to running a successful business, knowing whether or not your business is profitable, or waking up one day to find out you’re on the slow march to insolvency and going out of business. There are a handful of metrics I think every business owner should be familiar with, but I’ll preface my suggestions with the following disclaimer:
“I’m not an accountant and although I believe, from my personal experience, that these are some of the more important metrics every business owner needs to be familiar with, you should also speak with your accountant or a trusted financial advisor to see if there are any other metrics he or she feels are more important for your business and get their perspective on what these metrics mean and how you should measure them.”
In addition to being tools to help you successfully run your business, I once spoke with a lender who said, “If I can tell more about a business by looking at the financial numbers than the business owner, I’m not likely to offer them a loan.” In that sense, having a thorough understanding of what your financial reports are telling you also instills confidence in those that work for you, those that offer you credit, or anyone who otherwise helps you to succeed.
5 Important Small Business Financial Metrics You Need to Understand
Most of these metrics are pretty straightforward and logical, but hopefully I’ll be able to add something based upon my experience as a small business owner and shed some light on how I monitored these metrics in my business.
Income: Without business income, or revenue, nothing else happens. Nobody gets paid. Products don’t get delivered. Supplies can’t be purchased. Without revenue, businesses can’t sustain operations. In my opinion, this is one of the first metrics you need to be intimate with. I tracked this number daily, weekly, monthly, quarterly, and annually so I could compare how I was doing today with how my business was doing last year, month, week, etc.
This is an important number to a lender, for example. Because one of the things they are trying to evaluate when they review your loan application is whether or not you have the income to make any periodic payments associated with a potential small business loan, without revenue, your business’ ability to service debt will be considered questionable.
Fortunately, this is a fairly easy number to capture. What are your total sales?
Expenses: There are several ways to categorize your expenses, and your accountant can help you with those; but ultimately, you want to know what it costs to do business and whether or not your business income is sufficient to meet those business expenses. It’s the difference between your income and expenses that determine if your business is profitable or not. After all, profits should be one of the primary goals of going into business for yourself.
Granted, there are some businesses today (particularly in the tech space) that forego profits in the beginning and focus more on growth. To do this, they rely on investor income, rather than profits, to fuel the fire of growth before they become profitable. That’s how companies like Facebook, Twitter, and Uber became household names. These investors forecasted that their returns would be exponentially greater by investing today for a potential payout down the road. If your small business has the potential to grow and scale profits with the infusion of capital, you are probably considering this, but most small business owners need to focus on selling their goods or services for more than it costs to produce them so they can generate profits.
Cash Flow: Inadequate cash flow has rung the death knell for many small businesses over the years. If you’ve ever heard the term, “Cash flow is king,” this is what it’s talking about. It’s not enough to simply have money in your business checking account at the end of the month; you need to understand your Cash Flow Metric.
You calculate this metric by dividing your assets and your liabilities. This is an important enough metric, that if you’re unsure about how to define assets and liabilities, I encourage you to speak with your accountant to make sure you’re clear on the definitions. The ideal goal for this metric is 2:1, or twice as many assets as liabilities. Understandably, this 2:1 goal is challenging for many businesses to maintain, but anything below 1:1 should be a big red flag that your business doesn’t have adequate cash flow to maintain operations.
This can be an important metric. For example, it should be an important part of consideration when looking at a potential small business loan. Because the loan payment becomes a liability, if those payments pull your metric down below 1:1, it could indicate that you are borrowing your way into trouble. Having a handle on your cash flow metric is critical to small business success.
Accounts Receivable Aging: This is an important metric that you can’t afford to ignore. How long does it take your customers, to whom you offer credit terms, to pay their invoices? If you offer 30-day terms, do they consistently pay in 30 days or do they sometimes go 45 or 60 days.
In my business, after 45 days I started to lose whatever profit was in an invoice and after 65 days my profits were entirely gone because of the impact it had on my cash flow. What’s more, for every day over 40 days an invoice was late, it became more difficult to collect. (These timeframes might not apply to your particular business, but it’s worth investigating your situation to determine these numbers for your business.)
Needless to say, I worked very hard to ensure that my customers stayed current, and even encouraged them to pay early by offering them a discount on their invoice if they paid within 10 days. Those that took advantage of the discount helped my business by giving me 20 extra days to use that income to increase profits—in other words, the discount was worth it to me.
Accounts Payable Aging: Another number you should know is the average number of days it takes you to meet your business’ financial obligations. If you’re able to effectively manage your Accounts Receivable, your cash flow, and your income, you should be able to keep your accounts payable current and maybe even take advantage of the prompt payment terms you’re suppliers likely offer you.
I know of several small business owners who save enough money by paying their suppliers early and taking the offered discount that they take a big chunk out of payroll every month with the savings. What’s more, if you’re looking at your income and expenses, the ability to take that discount may even positively impact your profitability.
As a business looking for borrowed capital, the single most important thing you can do to positively impact your business credit rating and increase the options you’ll have when it comes time to borrow is staying current with your business credit obligations. That includes you utility bills, your business lease, your credit relationships with vendors, and any other business credit obligation you may have.
In my opinion, it’s important to have a handle on these five metrics to run a successful business. You may even want to dive a little deeper into one or two of them. For example, you can categorize income streams or identify particular classes of expenses that might make it easier to understand and control. Your accountant or CPA can help you identify the metrics that will give you the most insight into your business.
Don’t be afraid to ask him or her questions if there are terms or formulae you are unfamiliar with. You accountant should be able to explain them in terms you’ll understand. One of the big mistakes I made as a business owner was treating my accountant as a transactional relationship, rather than a consultative relationship that had the potential of helping me more easily grow my business. In hindsight, I wish I had leveraged that relationship more to my advantage.
Are there any metrics you think I might have missed?