Anyone who longs for the “good old days” probably doesn’t own a small business. Given the variety of powerful, easy-to-use accounting software products available today, it’s difficult to imagine wanting to keep records and prepare financial statements by hand. But while technology has eliminated the need for stubby pencils and green eyeshades, it’s
still up to the small business owners to analyze and understand the meaning of their financials in order to make wise decisions.
While there’s no hard-and-fast rule for reviewing financial data, most experts recommend
a minimum of monthly or quarterly evaluations. Otherwise, you risk spotting serious problems
too late to take corrective action.
Cash flow is a key indicator to watch. This is the revenue coming into your business
balanced against expenses (rent, payroll, supplies, etc.). Projecting cash flow into the future will
help alert you to potential bottlenecks in meeting payment obligations, and whether changes in
your collection strategy or operating budget are warranted.
Several financial ratios can also help small business owners gauge the health and
progress of their enterprise. Because these ratios fluctuate over time, tracking them will help you
better spot trends that could evolve into opportunities or problems.
Liquidity ratios measure the firm’s ability to meet short-term commitments from its
liquid assets. The current ratio (current assets/current liabilities) is a simple measure of a firm’s
ability to meet short-term obligations. Similarly, the quick ratio (current assets minus
inventory/current liabilities) measures the firm’s ability to meet short-term obligations from its
most liquid assets. The ideal average for both varies from one industry to another.
Leverage ratios indicate the company’s ability to meet both long- and short-term
obligations, making them particularly important to bankers and investors. The most frequently
used indicator is the debt ratio (total debt/total assets). Generally, lenders want this ratio to be as
low as possible.
Profitability ratios measure how well a company earns a net return on sales or
investments. Gross profit (gross profits/net sales) measures the margin on sales, essentially the
overall effectiveness of the business. Net profitability (net income/net sales) shows the
effectiveness of management in controlling costs.
Then there are activity ratios, which show how well a company uses its assets to generate
sales. Small businesses that manufacture or sell products should monitor inventory turnover (cost
of goods sold/average inventory), while businesses of all types should watch their average
collection period (average accounts receivable/average credit sales per day) to determine if they
are being paid promptly.
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