In the world of small business, entrepreneurs are responsible for learning and knowing something about every aspect of their business. From marketing and product management to customer service, technology and accounting, as a small business owner it’s imperative that you know enough about each aspect of the enterprise to supervise and ensure its success.
One of the essential functions that every small business owner needs to understand is core financials. Short of having a full-time CFO on your executive team (or partnering with a fractional, outsourced CFO to provide these services), it’s critical for you as the business owner to stay on top of the numbers.
Perhaps the easiest way to begin understanding this area of your business is to focus on two components: key numbers, and essential reports. The first article in this series focuses on numbers (also referred to commonly as metrics or indicators), and the second article focuses on reports.
Here below are five essential numbers you should know, master and track every day in your small business:
1. Cash Flow (is King)
There’s a reason behind the old adage that “cash is king”: the flow of cash in, through and out of your business is the difference between success, survival and failure every day. It’s utterly imperative for every business that cash flow be monitored on an ongoing basis. Cash flow is determined by taking the incoming funds that your business generates in the course of its operations, and subtracting operating expenses.
Make sure to incorporate key factors such as depreciation, accounts receivable, inventory carrying costs and monthly debt service payments in the calculation. It’s particularly critical that you monitor cash flow in the business checking account and payroll accounts at all times, and avoid letting the business slip into the red.
2. Gross Margin / Gross Income / Gross Profit
Whereas cash flow looks at the overall state of your ability to move funds through the business effectively and cover all liabilities, the gross margin looks at how much money is left after the actual cost of your products or services (called the Cost of Goods Sold, or COGS), is subtracted from the retail (or sales) price. For products, you’ll need to calculate production costs and for services, you’ll need to examine and accurately summarize labor and material costs.
Also, you need to consider overhead costs when determining these figures as well, since a portion of your business operating expenses (such as rent, utilities, marketing, sales, customer service, etc.) will need to be apportioned as well.
If your gross margin is low (or negative), then you’re not charging enough to cover your costs, and the business cannot sustain itself unless you raise prices, lower costs or otherwise reconfigure your approach to either operations or the marketplace.
3. Break-Even Point (or Price Point)
Calculating your break-even point is essential to establishing and protecting your margins and your cash flow. You also need to determine it before you fix your product or service pricing. The good news is that the gross margin calculation makes it easy to identify your break-even point. The break-even point is the point at which your gross margin is neutral (i.e. not negative and not positive). Another way to say it is that the break-even point represents the point at which your revenues cover 100% of your costs.
Identifying the break-even point is especially critical when you’re planning or launching a new product or service, or when you’re expanding the business with a new location or new operation of some kind. In each of these cases, you need to know how to price your products and services to cover your costs, and at what volume of sales.
If your business produces, warehouses or distributes physical products, then you need to monitor your inventory numbers regularly (most experts recommend a weekly basis). You want to ensure that inventory levels aren’t increasing, as a spike in on-hand inventory could indicate a dip in sales or other revenue problems coming up.
Remember that it is essential to manage inventory carefully. While your first objective is usually to increase sales and move inventory faster (increasing turnover), it’s equally important to balance inventory and demand so that when sales increase or decrease, you’re not caught flat-footed. Carrying excess inventory can be extremely expensive when you consider storage costs, handling costs, inventory taxes and potential loss (for products that expire or become obsolete).
5. Net Margin / Net Income / Net Profit
Gross margin is sales minus the cost of goods sold (COGS), as we discussed above. Put another way, gross margin is the amount that you’ll earn from the sale of your goods or services after you account for the cost of producing or delivering them. However, only net margin takes additional costs into account such as the costs of selling, administration, taxes and so forth. Since net margin takes into account all of a company’s costs, it is the figure we use to accurately calculate profit.
It’s important to understand how the two figures help you identify different factors that may be influencing the performance of your business. For example, gross margin gives you a strong picture of how your operating costs are are being managed. A lower-than-anticipated gross margin will most likely indicate that production and operational costs are problematic, or that there are issues with throughput (slower throughput results in increased direct labor costs for a lower volume of finished products).
In contrast, unexpected fluctuations in net margin generally point to other causal factors, such as administrative costs, sales expenses (i.e. is it taking more time, effort and money to secure a customer?), and of course taxes.
Learn and Know Your Numbers
Understanding and tracking these five figures will give you a solid first step on the journey of mastering the financial side of your business. Next, learn about the five essential financial reports that you should be using to track your business performance as well, in our next article.