“Accounting is the language of business” Warren Buffett
Authored by Chris Vanderzyden
Accounting, financial statements, forecasting, budgeting, taxes…Unless you are an accountant, most small business owners have very little understanding of the finance side of their business, and in order to be successful, it is imperative that you know and understand the language.
According to a recent report from the Small Business Administration, one-third of new businesses fail within two years, and fifty-six percent within the first four years. I actually thought these stats were pretty good – two-thirds stay in business for two years – not bad at all! But, how many are profitable? Only about 40%.
Why the lack of profits and thus the high failure rate? Incompetence, and one of the primary inadequacies cited is lack of financial knowledge.
I get it; the finance side of business is just not as sexy as the product development, marketing & sales, or whatever is your sweet spot in your business. However, it is critical to your success that you not only understand your financial information, but also utilize the data to make sound management decisions.
Hire a CPA and a bookkeeper to do the dirty work, but do not hide your head in the sand in regards to what your financial picture looks like. Your ability to read and properly analyze the information will ensure that your business continues to thrive.
Here are a few key points to understanding two of the basic financial statements – the Balance Sheet and Income Statement:
1. Balance Sheet – The balance sheet is a picture of the position of a company at a specific date. It provides the value of assets, liabilities and owner’s equity and provides the information necessary to determine the level of solvency and liquidity of a company.
A key indicator to liquidity is the current ratio: the ratio of current assets to current liabilities. Current asset are those assets that can be converted to cash within the current period such as, accounts receivable. Current liabilities are those liabilities that are expected to be paid off within a current year, accounts payable.
Computed: Current Assets / Current Liabilities
A 2:1 ratio (twice the assets as liabilities) is a good marker of a healthy small business.
Two additional balance sheet key ratios to consider:
Inventory turnover – the number of times that inventory is replaced in a period. This provides an indicator of how well the inventory levels are being managed.
Computed: Cost of Goods Sold (CGS found on the income statement) / Average Inventory in a Given Period
* Is your rate good? How is it trending compare to previous periods? Compare your turnover rate to your successful competitors.
Receivable turnover – is a measurement of how many times a business collects its receivable in a period or how efficient their collection process is. The goal is to collect receivables as quickly as possible, so the higher the ratio the better.
Computed: Credit Sales / Average Accounts Receivable
2. Income Statement – Displays all revenue sources and expenses for a given period of time. Three key analytics:
Gross Profit Margin = Sales – CGS / Revenue
Analyze – are you making a profit on the products you are selling?
Operating Profit Margin = Revenue – operating expenses (day-to-day expenses)/revenue
This will indicate how efficient your company is operating.
Net Profit Margin = Net income/revenue
This is the income derived from every dollar of revenue.
VICTORY TIP FOR THE WEEK:
Your financial statements are your greatest tools to identify weaknesses in your business. It will alert you as to when trouble is brewing and allow you to be proactive in resolving issues. Is there a problem in your inventory control? Do you need to tighten your cash management procedures? Is your pricing out of whack? Are your operating expenses eschewed?
Don’t hide your head in the sand—carefully and consistently analyze your financial statements, and watch the trends as you compare period-to-period. Your efforts will guide you to make better management decisions that will positively impact your bottom line. Trust me – it pays to fall in love with the language of numbers!
* This post was originally written and posted on ChrisVanderzyden.com– thanks to Chris Vanderzyden for sharing with us! We’re so excited for you to share this with our readers! Follow her blog for more amazing posts.