As an entrepreneur, you fulfill many roles in order to keep your business going. And when it comes to your business’s finances, it’s time to grab your doctor’s bag and take the temperature of your financial health.
To help ward off the out-of-business bug that infects the overwhelming majority of small business owners, we’ve identified five measurements that can gauge the well-being of your bottom line—and provided the prescriptions you’ll need to improve what ails your business.
1. Get back to accounting basics
You can’t assess your financial situation if your records are outdated (or nonexistent). If you cram receipts into shoeboxes and record daily transactions on cocktail napkins, it’s time to upgrade and standardize your accounting system.
At the heart of every accounting system beats a general ledger. All your daily journals, such as sales and cash receipts journals or cash disbursement journals feed into the general ledger. You can create a series of spreadsheets and worksheets to accommodate all your journals, or you can save yourself some headaches and opt for a mobile app or small business accounting software (which we highly recommend). Either way, the end goal is twofold:
- to record all your transactions consistently and promptly
- to use your data for analyses and predictions
Of course, spreadsheets or accounting software will provide a fine way to fulfill the former. And while you can cobble together formulae across spreadsheets to complete the latter, accounting software makes analyses and predictions far easier.
Accounting software also better ensures accuracy by using double-entry accounting, a system where every recorded transaction contains a debit and credit component. This system is preferred by accountants, recommended by the Toolkit editors and often required by the IRS for tax-compliant accounting methods.
Regardless of the system or entry method you choose, remember the most important part: Keep your records up-to-date. As the adage goes, you can’t improve what you can’t measure.
2. Check your liquidity
Just like you keep a certain portion of your personal assets liquid at all times (we hope), you’ll want to measure how much of your business’s capital is liquid at any given point. To properly check the liquidity of your business assets, you can use a series of liquidity ratios.
These ratios are among the most common of all business ratios. They are designed to measure your business’s ability to pay off short-term debts with cash on-hand, hence the importance short-term lenders place upon them. Some banks or other lending institutions will require you to maintain a specific minimum ratio.
The most common liquidity ratios are the current ratio (which demonstrates your business’s ability to generate cash to meet short-term obligations) and the quick ratio (which resembles the current ratio except inventory is not included in your current assets).
Current ratio. To find your current ratio, use x:y, where x represents the amount of current assets and y the current liabilities.
If your current assets including cash total $50,000 (x) and your current liabilities comprise $25,000 (y), your current ratio is 2:1.
A current ratio of 2:1 or higher is generally considered sound.
If yours is lower (such as 1:3), consider obtaining a long-term loan to pay off enough of your short-term debt to achieve a minimum 2:1 ratio. If your rate is spot on or higher, you can use your cash to pay down the short-term debt to achieve an even higher current ratio. You would also be prudent to consider investing some of your available cash.
Of course, the current ratio makes one big assumption: You can sell off your inventory easily in order to pay your short-term debts. But, as you already know, that’s not always possible. The quick ratio shows how liquid your finances are in a pinch and if you’re keeping too much inventory on hand.
Quick ratio. To find your quick ratio (also called an “acid test”), let x represent your current assets minus inventory and y your current liabilities.
If your current assets excluding inventory come to $75,000 (x) and your current liabilities equal $25,000 (y), your quick ratio is 3:1.
Considering a quick ratio of 1:1 is good, the example above is excellent. If your ratio, however, shows the opposite (maybe only $25,000 for x and $75,000 for y), take immediate action. Like fixing a current ratio, you can take out a long-term loan to pay off your short-term debt. Or, if the market is good, sell a portion of your inventory without ordering replacement stock in order to build your current assets without increasing your current liabilities.
Once you have a handle on your liquidity ratios, you can refine your cash flow budget.
3. Put your income statement to work
By analyzing your income statement (also called a profit and loss statement), you can find key insights into sales growth, attrition, expenses and more. This statement contains your company’s gross revenue (the “top line”) minus all expenses to show the profit or loss (the “bottom line”). Income statements are limited to fixed periods, usually three fiscal years.
By now, you’re probably seeing the value in getting your books up to snuff. Without maintaining meticulous records, you can’t produce an accurate income statement. And without an accurate income statement, you can’t properly diagnose your financial health.
Most income statements include three years of data and contain sales, costs of goods sold and expenses, like this example: