It’s important to determine where you stand when running a business. You might get so caught up in the day-to-day duties that you don’t step back regularly and look at the big picture. Here are 12 key areas to look at when assessing how your business is doing financially. Staying on top of these benchmarks can help you plan for the future and avoid financial problems.
Why value your small business?
If you’re seeking funding from lenders, investors, or other potential financiers, chances are you’ll need to prove your company’s worth. In the exact opposite situation – selling or stepping back from your business – you should know your company’s value so you know how much you can get for your business and what you can potentially earn from the transaction.
What is the best measure of a company's financial health?
The below metrics are among the best measures of good financial standing for a company:
- Total assets . Your tangible assets such as cash and physical property play a part in your company’s valuation. So too do intangible assets such as patents and trademarks.
- Liquidation value . Your liquidation value is the total value of your tangible assets. For this metric, intangible assets are not counted.
- Comparables . Instead of looking through your financial statements to determine your cash balance and liabilities, look at recently sold companies like yours. If you can find the sale prices of these companies, you can somewhat reasonably assume that your company’s value is similar. In reality, your actual value will differ based on several complicating factors, but comparables still provide a great starting point.
- Operational efficiency . This metric measures your company’s efficiency at earning profit as a function of its operating expenses. As a result, higher operational efficiency means a more profitable – and higher-value – company. While this metric paints a reasonable picture of your company’s balance between earning and spending, total assets and liquidation value are more direct measures of your company’s value.
- Solvency . This ratio compares your company’s assets to its liabilities. A solvency ratio greater than 1:1 means that your company has more assets than liabilities and thus has at least some value. Typically, you’ll use your balance sheet and cash flow statement to determine your solvency – and both these financial statements can also attest to how well your company is doing financially.
12 ways to tell if a company is doing well financially
You can use the below indicators to tell if your company is doing well financially:
1. Growing revenue
Revenue is the amount of money a company receives in exchange for its goods and services. The revenue received by a company is usually listed on the first line of the income statement as revenue, sales, net sales, or net revenue. (For help creating an income statement, visit the SmartBiz Blog: How to Prepare an Income Statement.)
Depending on your industry, there are tried and true ways you can increase your business revenue.
- Increase the number of customers : In short, bring more business in the door. Even if transaction sizes stay the same, more customers = more revenue.
- Increase the frequency of transactions : This means encouraging people to purchase from you more often. If your average customer comes in once a month, convincing them to patronize your business once a week will increase your revenue.
- Upsell : This is when you encourage your customer to purchase more of your goods or services. For example, if you own a beauty salon, suggest a manicure in addition to a haircut. If you own a restaurant, upsell additional purchases like drinks, appetizers, or a dessert.
- Raise prices : If your prices go up, you’ll collect more revenue from every purchase a customer makes – with the same amount of effort.
2. Expenses stay flat
Although expenses will increase as your business expands, they should be in sync. For example, if you experience a revenue increase of 5% year over year, you don’t want your expenses to exceed that percentage. In order to stay on top of expenses and how they relate to revenue, keep on top of your business expenses.
Our article, How to Keep Track of Business Expenses, gives 4 steps about how to track accurately. Tips include keeping personal and business expenses separate, choosing the right method to calculate, and keeping an eye on tax deductible expenses.
3. Cash balance
A low cash balance, perhaps as indicated on a cash flow statement, is an indicator of a company that isn’t doing well financially. Revenue could be increasing but if you just reinvest into the company, you’ll find yourself cash poor. For example, if you need additional inventory, equipment, or staffing, you won’t be in a position to cover those costs. Poor cash flow is one of the main reasons for small business failure. The SmartBiz blog has a number of articles that can help here.
4. Debt ratio
This formula measures how much your business owes vs. how much your business is worth and is expressed as a decimal or percentage.
According to Investopedia, a ratio greater than 1 shows that a considerable portion of debt is funded by assets. In other words, the company has more liabilities than assets. A high ratio also indicates that a company may be putting itself at a risk of default on its loans if interest rates rise suddenly. A ratio below 1 shows that a greater portion of a company's assets is funded by equity.
5. Profitability ratio
A profitability ratio measures your company’s performance related to the capacity to make a profit. Profit is defined as what is left over from income earned after you have deducted all costs and expenses related to earning the income.
Common profitability ratios include gross profit margin, operating margin, return on assets, return on equity, return on sales and return on investment. To learn more about these ratios and how to calculate, review study.com’s comprehensive article here.
6. Activity ratio
This ratio measures how your business manages its assets. There are several ways to calculate how your business is doing in this area:
- Asset Turnover : This calculation is sales divided by assets. Strive for a high asset turnover ratio.
- Inventory Turnover : A high inventory turnover ratio indicates positive management of inventory. Calculate by dividing your cost of sales average inventory.
- Operating Expense Ratio : Divide operating expenses by total revenue to determine how much you must spend to generate revenue. Strive for a low ratio.
7. New clients and repeat customers
Acquiring a new customer can cost five times more than retaining an existing customer. The success rate of selling to a customer you already have is 60-70%, while the success rate of selling to a new customer is 5-20%, according to ClickZ. Having a stream of both new and existing customers is an indication of business health. Every business loses customers so you need a healthy pipeline of new consumer purchasing your product or service to take their place.
8. Profit margins are high
A company’s operating profit margin, also referred to as its return on sales, measures the proportion of income to revenue. This number reveals how much profit your business is generating from sales and can help you set goals and gauge your progress. Lenders may require you to present your business’s profit margin to get a sense of financial health.
There are two main types of profit margins small business owners can use to calculate: gross profit margin and net profit margin. Read What Is a Good Profit Margin for a Small Business? on the SmartBiz blog to learn how to calculate.
9. Spending on inventory
By looking at your cost of goods sold (COGS), you can see just how much money you need to spend to keep operating in a financially healthy way.
According to the Bench Blog, COGS is the cost your business spent acquiring or producing items that you’ve already sold to your customers. Here’s how to calculate COGS:
COGS = Beginning Inventory + Inventory Purchases – Ending Inventory
From here, use this number to calculate gross margin, net sales revenue minus its cost of goods sold (COGS).
When looking at your inventory numbers, pay attention to shrinkage, the loss of inventory attributed to factors such as employee theft, shoplifting, administrative error, vendor fraud, damage in transit, or in-store and cashier errors. Keep accurate records to track inventory loss and put systems in place to combat it.
10. Financial ratio analysis
Through financial ratio analysis, you can determine what the line items in your financial statements tell you about your company’s solvency, operational efficiency, and liquidation value. This makes financial ratio analysis a quick way to value your company.
That said, you should always make sure to calculate several ratio values instead of just one. That’s because, on their own, individual ratios tell you next to nothing about your finances. Investopedia explains this distinction while listing several types of important financial ratios.
11. Balance Sheet
Since your company’s balance sheet attests to its short-term or instantaneous financial picture, it’s an easy reference point for determining whether your company is doing well financially. For a quick valuation, just subtract your total liabilities line item from your total assets line item. The result is effectively your bottom line and thus your company’s value. Learn more via the SmartBiz Loans blog: How to Create a Balance Sheet for Your Business.
12. Income Statement
An income statement is an extremely comprehensive financial statement that includes key valuation line items such as net income and the cost of goods sold. Your net income is perhaps your clearest indicator of whether you’re doing well financially. If your net income is low or negative, you can strategize how to lower your cost of sales for more profits.
Business owners such as yourself should especially pay attention to what you see in your income statement – few documents provide such meaningful overviews of your financial situation. Learn more via the SmartBiz Loans blog: Example of Income Statement, Format and Structure.
If you need help
Not every entrepreneur has the knowledge or time to handle the financial tasks needed to run a successful business. If you find yourself in need of some assistance, consider hiring an outside accountant or bookkeeper. As Richard Branson famously said, “If you really want to grow as an entrepreneur, you’ve got to learn to delegate”.
Our article, How to Hire an Accountant for Your Small Business, dives into signs you need an accountant, services provided by an accountant, and how to determine if you need to hire for a staff position or a contractor.
Are you seeking outside funds to spark growth? Lenders look at specific ratios to determine the health of your business. Those ratios include:
- Combined Debt Coverage
- Business Debt Coverage
- Business Credit
- Personal Credit
- Business Debt Usage
- Personal Debt Usage
- Business Revenue Trend
- If these ratios indicate that you’re in good shape, you’re much more likely to qualify for low-cost funds when you need them.