Did you know CPAs can measure the financial health of a business? If your sole measure of financial performance are the sales you generate or your account balance—you’re missing out on a lot of helpful information about your business.
Financial statements and metrics are more than just numbers that go up or down month after month. They tell a story about the health of your business, your ability to grow, and your ability to prosper. This information can help you build an awareness about your business finances. Most business owner will “check in” at least once a quarter, if not monthly. When you look at things too frequently, small variances can be distracting. In that case, set a regularly spaced rhythm for monitoring your financial health and watch the patterns and trends that emerge.
The three core financial statements you should review regularly are the following:
1. Income Statement
The Income Statement shows your income and expenses over a period of time. List any type of revenue you generate first, followed by all expenses broken down by category. Pay special attention to the two margins: gross margin and profit margin. Your gross margin should identify how much it costs you to produce every dollar of goods or services you sell. And the profit margin is what’s left after paying all the other expenses of the business (overhead, salaries, taxes, etc).
2. Balance Sheet
The Balance Sheet shows your assets, liabilities and equity as of a particular date. The logic of a Balance Sheet is that your assets always equal your liabilities plus your equity. Assets are all of the “things” your business owns: money in the bank, real estate you’ve purchased, buildings, equipment, furniture and intangible assets such as patents. Liabilities are all of the things you owe to other people: loans that must be repaid, credit card balances and unearned portions of revenue you collected.
Equity refers to parts of the business you own outright: the capital you and others contributed, and the accumulation of your profits. Expressing this a different way, everything you have in the business (your assets) you received in one of two ways: either by borrowing the money to get it (liabilities) or earning it (your own money or your business profits). And if you had to liquidate the business immediately, you would turn all of your assets to cash, pay off all of your debts and be left with your equity.
3. Key Metrics
Here are a few key metrics you can look at to measure your financial health:
Liquidity: Though many measures of liquidity exist, one that you can focus on immediately is the Current Ratio. The formula for calculating this is: Total Current Assets / Total Current Liabilities. It helps express your ability to cover all of your short-term debts with your readily accessible assets. A measure of 2:1 or more is generally healthy.
Cash Flow: Calculate your cash flow ratio using the following formula: Cash Flows from Operations / Total Revenue. For example, a cash flow ratio of 23.49% tells you that for every $100 of sales you have, you are generating $23.49 in operating cash flow for your business.
Profitability: Possibly one of the most useful metrics around, express your Profitability Ratio like this: EBIT / Total Revenue. EBIT is your earnings before interest and taxes. What this powerful measure tells you is the amount of profit you are creating for every dollar in sales. For example, a Profitability Ratio of 12.5% means that for every $100 in revenue you create, you are actually putting $12.50 back in your pocket. Think about the Profitability Ratio you would need to meet your goals.
Returns: The two most common expressions of economic return are Return on Equity and Return on Assets. Let’s look at another measure that might have even more value to a business owner: Return on Capital Employed (ROCE). Calculate your ROCE like this: Annualized EBIT / Total Invested Capital. This calculates the return on the owner’s capital investment and can help you measure how quickly you are adding to your net worth by operating this business.
Do a Health Check on Your Business
The business development cycle is about Innovation, Quantification, Orchestration. The more you can find ways to try new financial structures or systems, quantify the impact they have on your business, and then orchestrate them into your overall business system, the closer you’ll be to owning a real “money making machine.”
If you’re looking for some benchmark advice, try our benchmarking analysis or calculators on our website. They both do a great job of analyzing the vitality of your business and providing you with the financial insights.
Call Williams & Kunkel CPA today in Flower Mound at 972-446-1040 to have a chat and find out how you can grow your business.