You won’t have a business without sales. But to have a truly sustainable business, you need more than enough cash in the bank to pay your bills. Good financial health allows your business to thrive and, if desired, to continue to grow.
Here’s how to understand and improve the financial health of your business.
Why Small Business Financial Health Matters
When you feel healthy, everything is easier than when you are not well. It’s the same when your business is healthy; you are better able to handle the challenges that arise.
It’s also easier to get financing or attract investors when you have a financially sound business. If you decide to sell, you’ll probably have an easier time finding a buyer.
Here’s how to make financial health part of your business strategy.
What determines the overall financial health of a business?
You don’t have to rely on your intuition to determine if your business is healthy. There are common business measures and financial ratios that are used to understand the health and viability of small business.
Here are several ways small business owners can better understand the financial health of their business using financial data.
If the following information makes you feel overwhelmed, don’t worry. In a moment, we’ll offer some tools and strategies to make your job easier.
As a business owner, the first thing you want to do is build a profitable business. At its simplest level, this means you earn money. But there are actually several types of profitability ratios that can be used to analyze a company’s profitability: gross profit margin, operating profit margin, and net profit margin. Each will bring unique insights into the health of your business.
Analyze the balance sheet
The balance sheet shows the value of companies at a given time. It accounts for the assets, liabilities and equity of the company. The basic formula is usually assets = liabilities + equity.
Liabilities include what is owed by the business, such as loans and leases, but will also include current liabilities such as rent, taxes payable, and payroll expenses.
Assets include valuables that the business owns. This can include not only cash in the bank, but also accounts receivable, inventory and real estate. Intellectual property can also be an asset.
The owner’s equity is all that remains after the liabilities have been taken into account.
An income statement (also called a “profit and loss statement”) will provide an overview of the business’s income and expenses over a period of time. This can help you understand if your business is making money (or losing money).
You can create your own income statement or generate one from your accounting software. Either way, your overall goal will be to compare income and expenses. In the revenue category, you can have gross profit (revenue less cost of goods sold), operating profit (gross profit less operating expenses), and net income (income before taxes).
Analyzing your income statement allows you to assess whether increasing revenue or reducing expenses can help improve the financial health of your business. It can also alert you to situations where your business appears to be making more money but profitability is declining. And it can help you monitor your business’ financial performance over time.
The importance of cash flow management
How you manage cash flow will be key to the health of your business. A business that makes a lot of sales but struggles to collect payments and constantly pays its own bills late may not be successful in the long run.
Healthy cash flow means generating revenue with enough time for your business to pay employees, suppliers, taxes and other obligations on time.
Unfortunately, slow cash flow is a common problem for small businesses. There are several ways to measure cash flow. Among them, free cash flow is commonly used to determine cash flow available to pay debts, as well as to pay interest or dividends to investors.
After increasing profitability, improving cash flow can be one of the most important ways to impact your business.
Liquidity: what is it and why is it important?
A company’s liquidity often refers to the ease with which assets can be converted into cash in order to meet short-term financial obligations, that is, those due in a year or less. Without cash, a business may find itself in a situation where it cannot pay those bills and may be forced to borrow or even default.
Small businesses can maintain their financial health when they integrate systems
Most business owners don’t start a business because they want to look at financial statements, unless they start an accounting business! You’ll want to take advantage of systems and tools that will make it easy to track and improve the well-being of your business.
Select and adhere to a financial management system
You will need to choose a financial management system that works for your business. At a minimum, you will need three items:
- Professional bank account
- Corporate credit and/or debit card
- Accounting software
A business bank account should be the hub of all your business financial activities. Business income is deposited there and business expenses are paid from it.
Even if you use payment platforms like Paypal or Venmo, it’s wise to have funds from these accounts deposited into your business bank account so that you have a central view of your business finances. It can also be useful when it comes to getting approved for financing, as many lenders will want to review company bank statements.
Don’t confuse your business with your personal finances. If you need money from your business to pay for your personal expenses, pay yourself (as payroll or owner’s debit), then pay your personal expenses from your personal accounts.
A business bank account that provides insight into your business finances can help you identify trends and stay on top of your business health.
You will also need an accounting program. Even if you hire a bookkeeper, it’s a good idea to maintain your own access so you can check in periodically. If you need to hire someone else to handle your accounting, you can change access without wasting time.
Plan the unexpected
Just as an illness or accident can be a setback to your personal health, your business will likely encounter unexpected financial obstacles from time to time. A customer paying late (or never paying at all), inflation (!), a new competitor, a supplier going bankrupt, a lawsuit from an unhappy customer, equipment that needs to be replaced or purchased are not just a few examples. types of emergencies that may arise.
To play for the unexpected, you will need to prepare in three ways:
- Set aside cash reserves for emergencies.
- Get access to capital before you need it.
- Maintain adequate commercial insurance.
You cannot avoid, or even plan for, all potential problems. But you create a safety net that makes it easier to react when things go wrong.
Access to capital
Virtually every business should have access to a line of credit. With lines of credit, you can borrow what you need (up to your credit limit), when you need it. They are ideal for short-term financing needs.
In addition, a business credit card can give you access to a line of credit.
Additionally, you may need small business loans. For example, you might need a term loan to finance specific projects, commercial real estate loans, or specialized financing like invoice factoring to advance funds from clients who owe you money.
How to make financial health a priority for your small business
Building a financially sound business is a commitment. Just like getting into physical shape, creating routines and using available resources can make it easier.
Don’t be afraid to ask for help. Your accounting professional or a free business mentor from SCORE or your small business development center can prove invaluable as you work to make it a priority. The benefit of investing in the financial health of your business can be a business that supports you and your family financially for the long term.
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