When you feel healthy, you feel good. The same is true of small businesses; being financially healthy allows your business to operate more smoothly and focus on growth, instead of constantly playing catch up.
Here’s how entrepreneurs can understand and create good financial health.
Importance Of Financial Health
When asked how business is going, a business owner I know often replies, “I’m still paying taxes.”
But it’s not enough to just be able to pay taxes, make payroll, or even to have something left over at the end of the month. You want to be strong enough to handle the inevitable ups and downs of small business ownership, and to also be prepared to handle what comes your way.
What Affects Financial Health
Not making enough sales or expenses that are too high are two of the most common reasons businesses are not financially healthy. But there are many other sneaky factors that can weigh on business financial health:
- Not invoicing promptly
- Customers that pay slowly
- Charging too little (or sometimes too much)
- Rising expenses that cut into profits
- Changing economic conditions
- Supply chain issues
And more. What’s important to your business may not matter as much as others, but there are some key financial management tools and measures most businesses should consider.
Importance Of Monitoring Financial Health
Just like you may check your blood pressure, blood sugar, or weight as ways to help measure your physical health, there are ways to check your business financial health. Here are some markers worth keeping up with.
Cash Flow Management
Cash flow problems can sink a business slowly, or quickly, so it’s crucial to understand where your business stands. Operating cash flow measures the income coming into a business from its normal business activities. There are specific ways to measure cash flow using accepted accounting principles (the direct or indirect method), but generally the goal is to understand whether your business is making enough money to continue and to grow.
Revenue And Expenses
Monitoring your business income (a.k.a. revenues or receipts) lets you see how much money your business is bringing in on a daily, weekly or monthly basis and to understand whether revenues are generally increasing or decreasing.
Revenue is the money that comes into your business from sales of your products and/or services. Expenses are costs associated with running your business, including staffing, materials, and overhead.
Tracking and reviewing business expenses helps you understand where your money is going, and gives you a chance to evaluate whether those expenses are bringing value to your business.
Being able to make your business financing and loan payments on time is essential, not just for business financial health, but also to establish good business credit. (Payment history is a key component of business credit scores.)
Debt isn’t always bad. It can give a business runway while it works toward specific goals. But too much debt, or debt for the wrong reasons (to keep a business running without sufficient sales) can be toxic.
Financial Planning And Forecasting
It’s not enough to look at what’s already happened in your business. You also want to plan ahead to try as best you can to ensure you have enough money to take care of future expenses, or plans for growth. Business financial planning and forecasting involves looking at what you anticipate for revenues and expenses so you can prepare ahead.
How To Assess The Current State Of Financial Health
There are a few key ways to evaluate your businesses’ current financial health.
Business Credit Scores
Have you checked your business credit scores and are they good? Does your business credit report contain any red flags (such as late payments, judgements, liens, or collection accounts)? Some businesses will find they have low credit scores simply because they don’t have accounts that report. In that case, you may want to take steps to establish business credit.
Balance Sheet Analysis
Your balance sheet gives you a snapshot of what your business is worth at a given point in time. It’s broken down by assets, liabilities and shareholder equity.
For non-accountants, the idea of creating or reviewing a balance sheet may seem intimidating, but if your business bookkeeping is up to date, you can probably generate one with a few clicks in your accounting software. For most businesses, preparing and reviewing your balance sheet on at least a quarterly basis is a good idea.
Cash Flow Analysis
To analyze your cash flow you can start with your statement of cash flows (another financial statement you can likely generate quickly from your accounting software). Your goal is positive cash flow from your operations. There may be times when that doesn’t happen, but if you start to see regular periods of negative cash flow, you’ll want to make sure you are addressing them.
Break Even Analysis
Understanding your break even point can help you with critical decisions in your business, such as pricing. It takes into account both fixed and variable expenses, and can also help you understand how much money you’ll need before you start to turn a profit in your business, or on a certain line of business. The SBA offers a free break-even calculator.
Key Performance Indicators (KPIs)
Key Performance Indicators (KPIs) let you set and track progress toward specific business results. KPIs are quantifiable: “more sales” is not a valid KPI but “XX sales of XX product in Q4 2023” can be. It takes effort to establish KPIs and then track them but many small and large businesses find them useful.
Other useful metrics can include inventory turnover ratio, accounts receivable (A/R aging), customer satisfaction, and profit margin.
How To Improve The Financial Health Of Your Small Business
If, after reviewing your financial health you realize some changes need to be made, here are good places to start. What works for your business will depend on the specific challenges you are experiencing, so some of these may apply more than other.
If expenses are eating up too much of your profit, you may need to reduce them. This may be easy in some cases (just cancel that service you’re not using), but sometimes it can require really tough choices (such as laying off employees).
While higher sales is a common goal for most businesses, sometimes a business simply isn’t bringing in enough money and really needs to focus on increasing revenue. That may involve pricing changes, finding new customers, or selling more to existing customers.
Improve Cash Flow Management
Revenues and expenses are part of cash flow management. It also includes key steps such as collecting from slow paying customers or invoicing more quickly and requiring shorter payment terms or discounts for quick payment.
It could also mean hiring a bookkeeping service to ensure your financial data is up to date so you can review it regularly.
Debt Management Strategies
If you have business debt, you’ll want to review how much you owe on small business loans or debt, the interest rates and/or fees you’re paying, and how long it will take you to repay your outstanding balances. Can your business afford your current business debts?
Review your business debt-to-equity ratio, which indicates how much debt the company has relative to its equity. A high ratio means that the company has more debt than equity, and that may indicate problems managing debt.
Part of running your own business is knowing when borrowing money makes sense. Short-term financing for working capital, or small business loans to grow your business, may make sense if it’s part of your overall plan.
The most popular types of financing for small business include:
Business Line of Credit
If you don’t have a business line of credit, you may want to think about getting one. A LOC will give you access to credit when a short-term crisis or opportunity arises. It’s one of the most flexible types of financing available.
Business Credit Cards
Most business credit cards offer a line of credit with flexible repayment terms. Most issuers evaluate applications using the applicant’s personal credit scores and income from all sources. That means they are startup friendly, and are often available to new businesses that have trouble qualifying for traditional loans, or to businesses that need a fast, short-term loan. Business credit cards with 0% intro APRs can be valuable for short-term financing.
Business Term Loans
If you need to borrow for a specific purpose and know how much you need, a term loan can be a good choice. If you qualify, you’ll get a lump sum that you’ll repay over a set period of time. Interest rates may be fixed or variable.
Here a business is advanced a lump sum based on its past revenue history (often credit card or debit card sales). It’s often a more expensive form of financing, but it is also often lenient when it comes to credit scores.
Ensuring Your Business Is Setup Properly
Small business owners are often so busy running their businesses they don’t feel they have time to pay attention to the health of their business. But just like it’s dangerous to let your physical health slide, it’s risky to neglect your company’s financial health. Here are a few key strategies to ensure you don’t let that happen:
Separate Business and Personal Finances
Use a business credit card for business expenses (rather than your personal card), and a business bank account for business income and expenses that can’t be charged. Avoid commingling business and personal expenses.
Plus, many small business lenders require business bank statements to qualify for financing.
Use Accounting Software
Choose accounting software and keep your business financials up to date, or hire someone to do your bookkeeping for you. You’ll be able to easily create many of the reports you need to stay on top of the health of your business.
To be successful in the long run, your business needs more than just healthy sales. You need a financially healthy company. It’s (almost) never too late to start improving your business financial health.
The place to start is understanding the strengths and weaknesses of your business financial health, including revenue and expenses, debt management and cash flow analysis. Only by knowing where you stand can you begin to work on improving your financial health.
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