Your Business Is Profitable—But Could You Still Go Broke?
You might be excellent at running your business—but do you know how to manage your company’s finances? Even if your business is profitable, your cash flow may still suffer if you ignore your numbers.
You want to see a business owner squirm and run out of the room? Start talking about cash flow and financial ratios.
It’s not just small-business owners who shy away from the numbers. Recently, after going over a $24 million valuation with an owner in his impressive boardroom, he looked me straight in the eye and told me: “I don’t understand this stuff. I buy steel, and I’m good at it. If you want to know anything about steel, I can tell you.”
Numbers are the last topic most business owners want to discuss. Financial analysis takes time, as well as an interest in benchmarking and digging into the metrics. But ignore the numbers, and warning signs can go unnoticed.
Many business owners, like the client above, are excellent at running the business—but they never slow down to learn how to manage a business. And too often, their lack of interest comes back to bite them.
Even if you have a profitable business, you can still go broke.
Mind the Gap: A/P and A/R
For a number of years, my company grew by more than 25% a year—a couple of years, we managed to double our sales through acquisitions. We were profitable, but we never had any cash.
At that time, I didn’t understand why. A closer look at our accounts receivable and accounts payable days would have shown me. Our accounts receivable days were on the 27th, but our accounts payable days were on the 12th. That meant we were waiting 15 days from the time we paid suppliers until we received the cash from our sales.
As sales grew, so did our working capital requirement, and we needed a bigger line of credit. My banker covered me, but he still reminds me of the day my account was short $700,000—yikes. It’s a perfect example of how quickly a company can run out of cash.
Ready to develop your business background? Start with these three steps:
- Learn the metrics that matter.
It’s easy to get caught up running the day-to-day grind of your company. Before you know it, you’re just a “checkbook manager.” But if you don’t take the time to look at your accounting numbers or financial statements, you put yourself at risk of falling into a complacency trap like I did in the example above.
As painful as it is, learn the importance of accounting in your business. Start by understanding these key ratios that you can review on a monthly basis to see how your company is performing:
Current ratio: A liquidity ratio that shows your ability to pay short-term debts and other payables (those you owe within a year).
Accounts receivable: Amounts your customers owe you for the goods and services they purchased from you on credit. For example, maybe you typically give customers 30 days to pay; the amount of time those funds spend in accounts receivable before you get them are the accounts receivable days.
Accounts payable: Amounts that you owe vendors for services you purchased on credit. Accounts payable days are how long those funds stay in accounts payable before you pay them.
Inventory days: An efficiency ratio that measures the average number of days you hold your products before selling them (i.e., how long those funds are tied up in inventory).
Gross profit margin: A profitability ratio that measures how much you keep from each dollar of sales. It indicates the viability of a particular product.
Cash-flow margin: A cash-flow ratio that measures cash from operating activities as a percentage of sales revenue over a specific period of time. It shows how efficiently you convert sales into cash.
Debt service coverage ratio: How much cash flow is available to pay your current debt obligations.
These are just the basics of small-business management, but they’re a good start as you delve into the numbers.
- Track your inventory.
If inventory is not accurate, your financials won’t be, either. Just a couple of years ago, I started coaching a new client and noticed right away that his inventory number had remained constant for the past three years. When I asked about it, I got the typical response: “Inventory is a pain; I know that number is pretty close.”
If you don’t take the time to look at your accounting numbers or financial statements, you put yourself at risk of falling into a complacency trap.
At the end of the year, he realized his inventory was overstated by $70,000! When the number was adjusted, it increased the cost of goods sold, which destroyed the gross profit and made for a large loss in the month for which it was adjusted—and in year-end profit. Worse yet, the owner thought he was having a really good year—he didn’t realize $70,000 had disappeared without his knowledge.
- Leverage the available resources.
Small-business owners have a handful of places to turn if they want to learn about getting the financial side of their businesses on track. Start with your current business advisory team, including your banker, certified public accountant and other professionals. If you’re looking for something a little more in-depth, hire a business coach who teaches financials.
Peer groups are also an excellent opportunity to share and discuss financial matters. Some organizations, such as SCORE, offer free access to retired businesspeople. Another option is to review resources from the U.S. Small Business Administration, which helps Americans launch and grow businesses.
Finally, consider joining an association within your industry, such as the network of Small Business Development Centers. Conferences and other knowledge-sharing opportunities can help you see what challenges other business owners are facing and learn from them. Don’t want to commit to an outside resource? Sit down and read a book. The most important thing is that you take the time to learn.
Understanding your ratios, inventory and resources can come with a painful learning curve. But they’re vital lessons for how to grow your small business—even if you feel like running out of the room.
Originally published on 10/18/19 here: https://www.americanexpress.com/en-us/business/trends-and-insights/articles/your-business-is-profitable-but-could-you-still-go-broke