Signs Your Company Has Good Financial Health
When you think about your business, at first it's probably easy to determine whether or not your business is doing well. You can feel it by just observing the day to day operations. Being able to pay all your bills, pay yourself and your employees and you have money left over in your business, are all pretty obvious signs that things are going pretty swimmingly.
This method of doing business might work for you for a short time. You can take your eyes off the road for a second, but if you stop paying attention for prolonged periods of time, you’re taking a risk.
Instead of flying by the seat of your pants, let’s observe some things that will actually allow you to determine the health of your business. There are a variety of measurements to choose from. They range from simple observations to more complex ratios.
Some methods may be a great measurement for your business while others might not be applicable or appropriate. With that in mind, let’s get pretentious about finance and explore the things will help you determine if your company is in good financial health.
Revenue Is Growing
When you review your profit and loss statement, you should be seeing a growth in revenue over time - year over year and month over month. The growth doesn’t have to be gnarly. In fact, growing too fast can be dangerous. Steady growth over time demonstrates a strong outlook.
Your Expenses Aren’t Growing Faster Than Revenue
It’s totally reasonable that when you start to grow revenue, you may have additional expenses. For example, if you need to hire a contractor for the additional work or if you need to implement more software or maybe you just #treatyourself for all the hard work you’ve done growing your business.
Keep an eye on how expenses are growing. Make sure that the increases in your expenses don’t outpace the growth you’re seeing in revenue. An easy way to look at this is to look at it from a percentage increase. If your income has grown 4% over the last 6 months, make sure your expenses are growing no more than 4% over the same time period. The key here is making sure you're looking at the change over the same period.
(Pro tip, in case you forgot how to calculate a percentage change: First: work out the difference (increase or decrease) between the two numbers you are comparing. Then: divide the increase by the original number and multiply the answer by 100. If your answer is a negative number then this is a percentage decrease.)
I totally understand that “it takes money to make money” and using debt (loans or credit) is one of the reason’s why the economy of the United States is one of the biggest in the world. Leveraging debt is a way to increase revenue when you don’t actually have the resources you need. But in the long run, if expenses grow faster than income, the business won’t be sustainable.
You’ve Got a Mix of Repeat + New Customers
Acquiring new customers costs your business money, from marketing and sales to on boarding and educating your clients about why they need your product or service. When you have repeat customers, you’re not taking on additional costs. But having new customers protects you from relying on your current customer base to be your only revenue source. It’s an inevitability of business that sometimes you’ll lose some customers. Having new customers in the pipeline not only helps hedge that risk, it has the potential to increase revenue growth.
You’ve Got Money in the Bank
The result of revenue growing faster than expenses over time is money in the bank. A healthy cash balance is a sign of long-term growth. A low or stagnant cash balance is a sign that your business is not sustainable.
While it’s important to invest in your business to continue to grow it, you want to make sure to keep a healthy amount of cash (several months worth of expenses) in the bank. Cash in the bank is helpful if you lose a big client or if you are having issues with collecting on some outstanding payments. If an unexpected expense pops up, the cash reserve allows you to pay the bills to continue operations and to stay out of debt.
Your Debt Ratios Are Low
Alright, kids, shit is about to get mathy. The debt-to-asset ratio and debt-to-equity are two types of ratios you should pay attention to in your business. These are also called solvency ratios. Solvency is the ability to pay debts. These ratios are designed to help you measure and understand the degree of financial risk your business faces in terms of paying back your debt.
Debt-to-Asset Ratio
The debt-to-asset ratio is calculated with the following formula:
Total debt ÷ Total assets = Debt-to-Asset Ratio
You get your total debt and total asset numbers from your balance sheet report in your bookkeeping program.
This ratio measures the percentage of assets financed by creditors, compared to the percentage financed by the business owners. A debt-to-asset ratio of no more than 50 percent has been considered good. Some experts recommend a ratio of 2:1 or ~33%.
A high ratio might demonstrate that your business might have a hard time meeting its debt obligations. You can improve the ratio by increasing value of your assets or decreasing the amount you owe in debt. An increase in assets could come from increasing your cash balances or the value of inventory you have (if you have inventory).
Debt-to-Equity Ratio
The debt-to-equity ratio is calculated with the following formula:
Total debt ÷ Owners' (or Stockholder's) Equity = Debt-to-Equity Ratio
You get your total debt and total owner’s equity numbers from your balance sheet report in your bookkeeping program.
The debt-to-equity ratio helps you understand how much leverage (debt) you’re using to to make purchases that will improve your return. In other words, how much debt you’re taking on in order to purchase inventory or fixed assets like equipment. An increasing debt-to-equity ratio might be a sign to slow down purchases with debt. This ratio can be improved by paying down debt or increasing the earnings that stays in the company.
Your Profit Margins Are High
Unlike the desired low debt ratios, you want to have high profit margins.
A profit margin is the portion of your sales that is a profit. The profit is the difference between the amount you gained on a sale and the amount you spent to make the sale.
For example, let’s say a greeting card manufacturer just completed their bookkeeping for the year. They were able to see that they earned $50,000 in sales. And the total cost for production plus all their administrative costs, including taxes were $38,000. So the total net profit is $50,000 - $38,000 = $12,000.
Here’s how you calculate net profit margin:
Net Profit ÷ Revenue = Net Profit Margin
$12,000 ÷ $50,000 = .24
Multiply .24 by 100 to make it a percent and the net profit margin in the example above is 24%.
So even if you’re making sales, your net profit margin could still be low depending on a whole host of factors. Since the components of the equation are revenue and costs, anything that impacts those factors will impact your profit margin. Your pricing strategy, labor and production costs and administrative costs will all impact your net profit margin.
These are a good places to start, especially if this is your first foray into financial ratios. Remember that much of business is hypothesizing and testing. So now that you understand how to measure the health of your company and what things impact the measurements, you can start to hypothesize and make adjustments.