Small business owners wear a thousand hats. With all of the demands on their time, it can be a challenge to take a step back and come up with an accurate assessment of how their business is performing.
Financial statements are complex, and therefore easily (and often) ignored.
A bank statement is easy to understand, but unreliable as a barometer of business health.
Do you know for sure if your company is making money? Is it on the right track?
With the Money Mastery Roadmap, GT Business Advisory helps entrepreneurs become focused and effective business owners. Step number one is conducting a 3-Point Inspection: assessing the company’s performance by looking at the following three key numbers:
1) Net income. This one’s easy: it’s the bottom line on your income statement (P&L). If the number is positive, then you’re making money — at least in theory.
2) Cash balance. This number comes from the balance sheet, and is the sum of all bank account balances (or “cash & cash equivalents”). You certainly want this number to be positive, or you may be unable to pay your bills and keep afloat.
3) Operating cash flow. As the old saying goes, profit is an opinion, but cash is a fact. This number comes from the Statement of Cash Flows (an often neglected but critically powerful document). You will find it named something like “Net cash provided by operating activities”. It is the change in your cash balance that resulted from the day-to-day activities of your business. Ideally, this number should always be positive as well, and certainly MUST be so in the long run, or your business will run out of cash and die.
But it is important to do more than just look at these numbers in isolation. You need to look at their trends over time, and how they relate to one another. An easy way to do this is to look at these numbers for the past three years, and ask yourself:
- Are all three metrics positive and growing over time? If not, why not?
- Is the cash balance growing more slowly than net income? If so, why?
- Is operating cash flow significantly lower than net income? If so, why?
Comparing these three numbers over time provides critical top-line information on how your business is doing. That is why the Baseline Check is the first step in the Money Mastery Roadmap. If this analysis provides nothing but good news, then you can feel pretty confident that there are no obvious negative trends impacting the immediate financial health of your business.
If the answers are negative, or more ambiguous, you will need to dig deeper. If your cash balance and/or operating cash flow are underperforming net income, the most likely culprits are to be found on your balance sheet: Accounts Receivable, Accounts Payable, and Inventory.
Accounts Receivable represents the total value of invoices that you have sent to customers which have not yet been paid. In accrual-based accounting, when you create an invoice, that dollar amount immediately goes on your books as net income. But the cash is not yet in the bank. So an invoice for $1000 will increase net income by $1,000, but operating cash flow and your bank balance don’t budget by a penny. The larger your A/R balance, the wider the gap between net income and your actual cash resources. So the goal is to collect payments quickly from your customers, and keep A/R as low as possible
Accounts Payable is the total amount of bills you’ve received from vendors that you have not paid yet. Again, in according to accrual accounting rules, those bills are immediately deducted from net income, but they don’t affect operating cash flow or your bank balance. In this case, however, A/P works in your favor. A vendor bill for $1000 will reduce net income by that amount, but your cash resources don’t change. The larger your A/P balance, the more cash that remains available to fund your business. So the goal is to pay vendors as slowly as they will allow.
For example, you may the kind of person who likes to pay their bills immediately. That is a fine practice in your personal finances. But in business, if your suppliers give you 30 days to pay them, you should pay them on day 30 (or maybe day 29, to allow for any hiccups).
Inventory is the value of goods for sale that you have in stock. (If you are in a services business this likely does not apply to you, so feel free to skip ahead.) Buying that inventory costs you cash at the time you purchase it. But accrual accounting says that you cannot record an expense for inventory until you’ve sold it. So your operating cash flow and bank balance will go down when you acquire the goods, but net income won’t budge until they go back out the door. This is why managing your inventory is so important. The greater your supply of goods waiting to be sold, the less cash you have available to pay your bills and stay afloat. The goal should be to keep in stock the minimum level of inventory necessary to avoid disrupting your likely sales and keep inventory levels as low as you can.
In sum, if your operating cash flow and cash balance are growing more slowly than net income (or shrinking, for that matter), the first place to look is the trends in your Accounts Receivable, Accounts Payable, and Inventory.
Paying Yourself Too Much? There’s one additional scenario to consider – when your net income and operating cash flow are healthy, but your cash balance is lagging. In that case, one likely cause could be that you are paying yourself too much.
To investigate this possibility, look to the “Financing Activities” section of your Statement of Cash Flows. This should detail all of the Owner’s Distributions that you took, which reduce cash balance. (If you pay yourself a salary, you can also take your salary payments from the income statement into account.) If the total amount you paid yourself exceeds your operating cash flow, you as the business owner are the culprit, and you may need to right-size your compensation to suit the current size of your business.
There are a host of other factors that could be impacting your results. But the ones described in this post are amongst the most common and likely problem areas for most small businesses.
Now you know the first step you must take to achieve money mastery in your business, by doing a 3-Point Inspection.
Want some help? We can offer you a 3-Point Inspection for just $97. Click on “Schedule time with me” below to set up an appointment.