WATCH YOUR BUSINESS’S FINANCES
You have to know a little bit about everything. The goal is certainly NOT to turn you into a bookkeeper but to become financially literate. Understanding finance won’t make you rich, or accountants would all be millionaires. But being financially illiterate will always be a disadvantage to your business.
You need to understand how the game of business is played. In addition, you’ll likely have to speak with finance partners (such as bankers, CFOs and accountants) on a daily basis, once you reach a certain point.
Is there a difference between ACCOUNTING and FINANCE?
Absolutely.
Accounting = converting activities into numbers; the translation of facts into figures; analyzing the activities and reviewing the detail on spreadsheets.
Finance = converting numbers into activities; the translation of figures into facts; analyzing the numbers and telling the whole story.
Finance is the language of business. That’s why FINANCIAL ACUMEN is such a sought-after skill—way more than accounting.
It’s easier to transcribe facts into a chart (accounting) than it is to interpret what’s happening in the real world, based on a given set of numbers (finance).
That’s why private equity firms, investment bankers, and the people who work in the Mergers and Acquisitions industry earn big money, more often than not. Their aptitude to read the numbers, explain the past, and make projections allows them to make wise investment decisions. That’s how I’ve grown my businesses. When you have the skills in finance, everything becomes clearer and easier. Again, it’s the language of business.
Lots of people can read the events, but very few people can read the numbers. Both accounting and finance are about the logic behind the business. That’s why it’s important to KEEP TRACK of all your financial documents such as invoices, credit notes, employment agreements, bank statements, and so on.
People are rarely enthusiastic about finance and accounting. I bet it has a lot to do with how business schools teach it in their tedious theoretical approach. Perhaps that’s also the reason why many accountants come across as boring. That’s what they’ve been taught to be. They’ve become a product of their environment.
Only 2–3% of businesspeople are financially literate. And 2–3% is also the typical success rate associated with entrepreneurship. Is it a mere coincidence? I don’t think so.
The game of business is simple. The economic value of your business is created by:
That’s it.
All the numbers, spreadsheets, key performance indicators, and ratios tie in with that. Like a pilot in an airplane, there are indicators you must keep an eye on—even when you’re on autopilot. I won’t show you all the details here (there are other books on that), but I’ll share with you the very basics to help you understand your business’s finances. We’ll be reviewing the three major financial statements and the most useful ratios to analyze them.
This isn’t an exhaustive list, and I’m not giving you generic accounting rules and principles. What I’m providing here is an opinion about what has worked for the successful companies I’ve run and worked with.
THE THREE MAJOR STATEMENTS
>> Value is created with what you have: the ASSETS. What you have is somewhere in your balance sheet.
Everything that you have is either financed by debt (liability), or belongs to you (equity).
It’s a snapshot taken at a specific point in time, at an exact moment or date.
>> How your business is performing is visible in your income statement (also called the profit and loss statement).
It shows how your business is doing in terms of sales, expenses, and profit (if any).
It covers a period of time, not a specific moment. It could be a year, a month, a week.
I recommend getting your income statement in four different forms:
You would refer to the first three on a regular basis, and to the fourth once every quarter.
>> You can survive (for a while) if you don’t make a profit, but you can’t survive if you run out of cash. That’s why you have a cash flow statement.
This one shows WHEN an action actually impacts your business’s cash—at what moment in time a sale was actually charged and when an expense was actually paid.
It covers a period of time, not a specific moment. It could be a year, a month, a week.
THE MOST IMPORTANT FINANCIAL RATIOS
CURRENT RATIO
Formula = current assets ÷ current liabilities
Among your tangible assets, three of them are called current assets, or short-term assets: your available cash in the bank, your accounts receivable, and your inventory. These assets are always in motion and are expected to be employed (used or sold) in a typical business cycle.
Your other tangible assets such as equipment, real estate, vehicles, and furniture are called fixed assets or long-term assets.
In addition to these, there are your current liabilities: that’s everything that your business should pay within twelve months, such as your accounts payable, or the amount of the long-term debt that your business will pay within twelve months. In addition, there are fixed liabilities, which typically include long-term loans used to purchase major equipment, properties, or competitors.
The current ratio tells you how many times you can pay your short-term debt by using your current assets. It means that if your result is 1.4, for each dollar of debt, your business has $1.40 in assets to repay it.
The higher this number (above one), the greater the financial position of the company. If you’re anywhere below 0.5, your business might be at risk, unless cash moves very slowly in your industry or you have too much inventory. If you’re above 3, you’re probably playing it too safe and not deploying your current assets efficiently.
These are, of course, general rules, but there are exceptions. Talk with your financial advisors for a deeper explanation and context regarding your own business.
WORKING CAPITAL
Formula = current assets – current liabilities
It compares the same numbers as previous, but it’s more concrete, since it provides you the result in dollars (or any other currency) instead of a percentage.
QUICK RATIO
Formula = (cash + accounts receivable) ÷ current liabilities
You do the same calculation as for the current ratio, but you exclude the inventory.
CASH RATIO
Formula = cash ÷ current liabilities
You do the same calculation as with the current ratio but you exclude inventory and accounts receivable. An efficient cash ratio is considered to be anywhere between 0.5 and 1. It means that if your result is 0.6, your company can’t pay its current debt with the cash available … which is nothing abnormal.
These four liquidity ratios (current ratio, working capital, quick ratio, cash ratio) are used to see if your business is at risk of not being able to pay its debt. You still might wonder if a result you got for your business is a good or bad ratio. The best thing to do is to monitor it over time and to try to understand its direction of travel, its trajectory, and why it’s moved up or down.
DEBT TO EQUITY (D/E)
Formula = total liability ÷ equity.
Your business is funded by two main sources: owners’ equity and debt. This ratio tells you how much debt you leverage to run the business. For most companies, the normal range is between 0.8 and 1.2, but debt is not necessarily a bad thing. To grow fast enough, your own capital is sometimes not enough. It means that if your result is 0.9 for a dollar of equity, your business has 90¢ of debt.
Using debt to finance assets is called LEVERAGE.
RETURN ON ASSET (ROA)
Formula = net profit ÷ total assets
You can find your net profit in your income statement and your total assets in your balance sheet. It means that if your result is 16, each $100 of an asset your company uses generates $16 in profit annually. Each industry is very different regarding how they use their assets, so there’s no golden range. Just monitor yours over time. If it’s growing and looks too good to be true, it might be that your business needs to renew its assets, and that an investment will be needed soon to stay competitive.
RETURN ON EQUITY (ROE)
Formula = net profit ÷ equity
It tells you the profit that’s returned as a percentage of owners’ equity. If your result is 40, it means each $100 of equity your company uses generates $40 in profit annually.
DAYS SALES OUTSTANDING (DSO)
Formula = average accounts receivable ÷ (annual sales ÷ 360)
It measures how many days on average your company takes to get an actual payment for sales that were delivered. In some industries, the average is ten days, in others it can be 100 days. So monitor your business’s DSO and try to decrease it. The faster your business collects it, the more cash it’ll have readily available.
DAYS PAYABLE OUTSTANDING (DPO)
Formula = average accounts payable ÷ (annual sales ÷ 360)
It measures how many days on average your company takes to pay for products or services that were delivered. This number must be greater than your business’s DSO to maintain a positive cash flow. Don’t be overly slow to pay your important suppliers though, or it might harm their trust and jeopardize future deliveries.
REVENUE PER EMPLOYEE (RPE)
Formula = total sales ÷ number of employees
This ratio shows you the average efficiency of your employees.
COST OF GOODS SOLD (COGS)
Formula = opening inventory + (material + labor necessary to make the goods) – closing inventory
It excludes your distribution or delivery cost. When you subtract your COGS from your revenue, you get your gross profit. If you don’t sell products, you don’t need this one.
OPERATING COSTS
Formula = COGS + operating expenses + overhead expenses
That’s where you put your distribution, labor, shipping costs.
MARKETING COSTS
Get it in absolute terms AND in % or revenue
It may have ups and downs depending on your activity, your projects, your strategy. As long as it’s expected and under control, it’s OK. Personally, I devote 15 to 20% of my businesses’ revenues for marketing.
PAYROLL
Get it in absolute terms AND in % or revenue
You want to hire superstars, but you want to keep your payroll expenses under control.
THE RIGHT USE OF KPIS
Some of these KPIs might seem obvious, but even with all the above in mind, it’s still not an exhaustive list of all KPIs your business has; I’m just giving you the ones I’ve seen high performance businesspeople use the most. It’s up to you to dig deeper and find the most important ones for your business, the ones that will help you make the right decisions regarding your strategy. There are KPIs that I closely watch in one of my businesses that I don’t monitor at all in another one.
For each of these indicators, even if the number you get doesn’t mean a thing to you for now, monitor it over time, and it’ll all start to make sense, because you’ll have a benchmark to compare it to. You can measure the trends and the relationship between a given set of numbers within a time period. That’s why we refer to these finance figures a scorecard. You can compare your numbers over time to see what your business needs improvement on and establish where your team is performing well.
When you compare your numbers, ask yourself these questions:
The most important thing to remember is that, over time—depending on your industry, priorities, and the growth stage of your business—you’ll find that among all these figures and ratios, a handful of them (three to six) will warrant close monitoring. Measure and monitor the trends of the FEW critical drivers of your business, not the trivial many. Always keep in mind the 80/20 rule.
Different indicators require different frequencies. For instance, your balance sheet and profit ratios ought to be monitored monthly or bi-monthly, while cash and revenue should be monitored a couple of times per week. Share your findings to the appropriate people, and make sure you hold yourself to the same standard.
Keep in mind that the game of business consists of converting ASSETS into CASH.
You have ASSETS. Assets produce REVENUE. Revenue generates PROFIT. Profit converts into CASH.
Let me reiterate: you start with some ASSETS—tangible (savings, inventory) or intangible (knowledge, connections). If you use your assets well, you’ll generate REVENUE. If you manage your revenue well, you’ll generate PROFIT. If you collect your profit well, you’ll generate CASH. Then with your cash, you buy other assets.
Marketing indicators are also important, especially at the earlier stages.
What’s your projected increase in sales?
How many clients do you need to reach your goal?
How many quotes do you need to submit to get these clients?
How many inquiries do you need to get these quotes?
How many visitors do you need to get these inquiries?
How many clicks/ads/phone calls/appointments/networking events/speaking engagements do you need to close a sale, then to attain your goal?
Regardless of the medium you use to make your sales, you need to know these numbers by heart, like the back of your hand.
But once you hire a CMO, they’ll take care of analyzing and monitoring this data. The more you grow, the more you’ll concentrate your attention on the macro KPIs.