Make sure to join my private Facebook Group named "Online Capitalists". Join now!
If you don’t know your numbers, you don’t know your business.
This is a phrase that you, as an entrepreneur, should always keep in mind.
Accounting and financial management might not be one of your areas of expertise, but if you want to run a successful business, you should monitor, track and review certain financial numbers.
I know that it is probably more exciting to work on creating a great product for your customers or launching a powerful marketing campaign that will boost your sales, but unless you know your numbers, your business is built on shaky ground.
Want to get my eBook "From Employee to Online Entrepreneur" as a nice PDF? Download it below!
Knowing your Numbers
Billionaire restaurateur Tilman Fertitta, star of the show Billion Dollar Buyer (which I recommend watching after you are done with the trifecta of entrepreneurial shows), says:
“Ask me anything about my business. Anything. I’ll know it all”.
You can surely bet that he knows his financial numbers too.
You don’t need to become an accountant or bookkeeper, but you certainly need to have a basic level of understanding of the key financial metrics.
Several business owners are ignorant about their company’s finances, and thus unable to make informed business decisions.
Their business model might be unoptimized, or even outright flawed, and they have no way of discovering this since they do not understand the language of business.
Legendary investor Warren Buffett has vividly expressed this in his quote:
“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself”.
Buffett is mentioning this in the context of selecting stocks, yet what makes a great stock is also what makes a great business. The concepts are very similar.
Fundamentals of Financial Management
With the help of your accountant, CPA, financial analyst or CFO, you should be tracking several numbers coming from the basic financial statements, namely:
Balance sheet: Provides a summary of your business’s assets and liabilities at a specific point in time (think of it as a snapshot).
By assets, we mean pieces of property or equipment which are purchased and used by the business for its operations. Business assets can be anything from cash on hand, to buildings, trademarks or receivables.
By liabilities, we mean obligations that your company has to third parties. Those arise from its operations and might include debt (e.g. bank loans), accounts payable to vendors, wages accrued, interest payable and others.
Income statement: Summarizes the company’s revenue (or sales), minus the cost of goods sold to determine the gross profit, minus all other costs to calculate the net profit. It’s also known as the Profit and Loss statement (P&L).
The Income Statement is mainly used to compare the company’s revenue against its expenses in order to calculate overall profits. Tracking Income Statements over a period of time helps a company evaluate where they can grow revenue (or the Top Line), reduce expenses and ultimately increase Profit (or the Bottom Line).
Cash Flow Statement: Summarizes how much cash is going in and out of your business during a specific period of time. It is built by analyzing operations, financing activities and investing activities to calculate current cash on hand and also predict future amounts.
A cash flow statement essentially depicts the flow of money into and out of your business. It’s all about tracking liquidity so that you can wisely decide how to allocate your cash, for example by acquiring more inventory, spending more on advertising campaigns to scale the business etc.
In order to have an accurate and complete view of your company’s financial profile, you need to keep an eye on all three financial statements.
I am highlighting this because most people think that focusing on only one of those (usually the P&L) is enough for measuring your business financial health. It’s not! You need all three of them.
Numbers You Have to Know About Your Business
Equipped with the fundamental financial statements, we are now ready to narrow our focus on certain financial numbers.
No matter what your business is, you need to know your critical numbers, monitor and track them carefully over time and finally compare them to key industry ratios.
Here are some of the most critical financial numbers you should have your eyes on:
1) Revenue (or Sales)
Revenue refers to the amount of money that a company receives from its operations during a certain period of time. Revenue is the amount of money that is brought into a company by its business activities and is also known as sales.
It is useful to track revenue monthly, quarterly and annually, and also to perform forecasts and projections about the expected figure over the next period of time.
If there is a number that most business owners know, it is probably revenue. Unfortunately, revenue on its own does not provide the overall picture, and at times can be greatly deceiving.
Sales is the bloodline of a business and its importance cannot be understated. However, it must be monitored in conjunction with bottom line performance as well, i.e. total profit. The reason is that profits can evaporate if the relevant costs are not kept under control.
At the same time, since revenue booked now might not translate into actual cash until a long time in the future, cashflow calculations should also be carefully monitored.
2) Expenses (or Costs)
These mainly come in the form of Cost Of Goods Sold (COGS), i.e. direct costs related to the production of the goods sold, and in the form of Selling, General & Administrative Expenses (SG&A), i.e. direct and indirect selling expenses and all general and administrative expenses of the company.
In general, you should try to keep costs down by avoiding purchases that will not increase the value of your product and company. For example, leasing a fancy office and buying lavish furniture while your company is at its infancy, is not a prudent decision.
On the other hand, investing into Research and Development, or increasing your ad spend when you have created an effective marketing campaign, are instances where increasing your short-term costs makes sense, since you are expecting to receive a greater return in the long run.
Profit (or earnings) is calculated by taking revenues and subtracting the various costs of doing business, along with some other items like, depreciation, interest, taxes and any other miscellaneous expenses.
As with revenue, you should track profit on a monthly, quarterly and annual basis, and also try to make projections about future values.
People tend to focus on and brag about their high revenue figures, but if those do not translate to robust profits, they are rather meaningless.
For a mature and stable business, profit is perhaps the most significant number and the one that better represents the financial performance of a company.
For a new and unproven business, achieving profitability might be pushed aside (or even might be impossible), in favor of quickly ramping up revenue.
If the finances permit it, it usually makes sense to forego a few years of profitability so that the proceeds are reinvested into the business to make it grow faster and stronger.
4) Profit Margin
Profit margin is calculated as the ratio of profits to revenues of the company expressed as a percentage. It represents what amount of revenue earned by the company is eventually converted to profits. The higher the profit margin, the more efficient a company is.
As we stated above, in a new company, profits and therefore profit margins, might be depressed since revenue is still quite low and costs (fixed and variable) consume a large portion of the income.
For a more mature company who does not grow that much, achieving high profit margins is very important since that is how shareholders are going to be compensated for owning it (e.g. via dividends).
Cash is simply all the money your business has in checking or savings accounts.
A healthy level of cash provides assurance to your business and frees your mind to deal with daily operations and perhaps strategic planning.
It is important to keep in mind that most companies go bankrupt because they run out of cash, and not because they have low revenues.
Having cash in the bank is what is going to save your company when the next recession hits or when something unexpected happens (a fire accident, a lawsuit etc.).
It also protects you from being squeezed in a negotiation either from your investors, bank or vendors.
One of your main jobs as business owner is to always make sure that there is enough cash in the bank.
By equity we mean the money invested and retained in your business by the owners and/or shareholders.
A company may raise capital via equity or debt (debt will be examined below). Giving away equity of your business literally means giving away a piece of it, so you should be extra cautious with that.
Legendary business owner Felix Dennis argues that you must fight tooth and nail before you grant a piece of your company to another person.
As your company grows, more capital might be provided in the form of equity by issuing more shares of the company. You should be aware of the equity structure (i.e. who owns what percentage of the company) at all times.
Special mention should be made of Owner’s Equity, which is the Assets minus the Liabilities of the company.
If this equation results in a negative figure, it should be a red flag for that business. It essentially means that the company has been accumulating losses and might be in a risky situation. On the other hand, if the figure is positive and growing, it points to a financially robust business.
By debt we mean any loans taken by your business that must be repaid, usually with interest, over a period of time. As we mentioned above, debt is an alternative means of raising capital and funding the needs of your business.
Repaying debt is legally binding, so you should take extra caution how much and on what terms you raise it. In general, the less you need it, the more favorable terms you are going to get.
Debt can be short term (due before a year’s period) or long term (due after a year or more).
For a person, debt can be used constructively (e.g. investing in self-education) or destructively (e.g. by succumbing to consumerism and spending it to useless stuff). Exactly the same applies to a business entity.
A business can leverage debt to expand operations and accelerate growth of a proven business model, or can waste it via mindless spending and extravagant purchases.
8) Tax Rate
What many business owners tend to forget is that their businesses need to pay taxes on profits. From sales tax to income tax, (local, state and federal) governments do their best to capture a significant portion of a company’s earnings.
You should consult with your tax advisor on the best ways to minimize tax liabilities. There are numerous way to legally lower your tax rate, e.g. by using depreciation, writing off business expenses and more.
If worse comes to worst, you could also consider moving the physical location of your business. With globalization, the world has become very connected and transfer of capital is easier than ever, so you should be able to capitalize on that.
This is an area that online business shine, since they are not bound by location and can be easily and swiftly migrated to different jurisdictions.
Please note that I am NOT an accountant or tax advisor, so everything said here is for informational purposes only. You SHOULD have a competent tax expert that you can rely on.
9) Accounts Receivable
This figure refers to the money your company is owed from sales of your products or services and is part of your Assets. You can think of it as outstanding invoices your company has or the money it is owed from its clients.
Most companies operate by allowing some portion of their sales to be on credit and agreeing on the payment terms. An example of a common payment term is Net 30 days, which means that payment is due at the end of 30 days from the date of invoice.
Lots of business owners book revenue but then fail to collect the relevant payments, either by negligence or by doing business with untrustworthy clients. You should make track all pending payments and nudge the debtors to always pay within the relevant time window.
10) Accounts Payable
This figure refers to the money your company owes to creditors, usually vendors that have purchased products or services from. It is essentially the opposite of accounts receivable and, as you might have guessed, belongs to the Liabilities of a company.
It makes sense for a company to delay paying its accounts as much as possible, since that will improve its cashflow. Whenever you are in position to do so, you can negotiate favorable payment terms like Net 90. Bear in mind though, that you should strive to always pay on time and establish yourself and your business as a credible business partner to others.
11) Quick Ratio
This figure (also known as Acid Test) is a ratio calculated by measuring Cash plus Accounts Receivable plus any short term Investments, divided by Accounts Payable (or Current Liabilities, meaning short-term ones).
The Quick Ratio is a strong indicator of whether a business has sufficient short-term assets to cover its immediate liabilities and essentially shows if it is in position to properly continue its operations.
The acceptable range for Quick Ratio varies from industry to industry, and comparisons are most meaningful within a specific industry. For most though, the acid-test ratio should exceed 1.
Companies with an Acid Test ratio below 1 might not have the liquid assets to pay their current liabilities and could be in a risky situation.
Understanding and knowing your critical financial numbers might not be as exciting as scoring a big sale or designing a cool new feature, but it might be the difference between a successful and a bankrupt company.
Tracking the major figures of your business will give you precious peace of mind and will allow you to make informed decisions about its future. Overall, it will make you a better business owner and entrepreneur.
Math is the language of the universe, and accounting is the language of business. Treat them both with the respect they deserve.