Although the economy has mostly recovered from the effects of the Global Financial Crisis, the climate is still largely uncertain for small businesses. According to statistics, more than 20% of small businesses fail within their first year, while only 50% make it to year four. This happens for a number of reasons, including insufficient demand for the products they offer andpoor communication with customers.
However, most small businesses fail due to problems with the cash flow and the financial structure of the company. All these financial hardships stem from the owners’ lack of understanding of vital financial metrics of their business, which, in turn, prevents them from monitoring its performance and health.
Whether you already own a fledgling startup or are getting ready to launch one, here are the five key financial metrics you should know to secure the successof your small business.
Without revenue, your business can’t survive – it’s as simple as that. Revenue is the amount of money you earn from selling your products and services to customers. If you’re not generating sufficientrevenue, you won’t be able to pay your employees, your suppliers, or your distributors.Once you subtract all these operating costs from your revenue, you get another important metric for your small business – income.Ideally, your income should be considerably higher than what you spend to keep your business running.
Your revenue and your income are particularly important if you plan to take out working capital for your fledgling enterprise. For your cash advance provider, these metricsare proof that you’ll be able to service your working capital in due time. If your small business isn’t generating enough revenue or if your income is too small, you might find it difficult to receive the funding you need to stay afloat.
All businesses have operating expenses that they have to cover. These can include payroll, rent, the cost of inventory, materials and office supplies, insurance premiums, professional fees and bank fees and interest expense on borrowed money. Businesses need to ensure that their revenue is high enough to still be in the black after all these expenses have been paid. However, not all businesses focus on revenue at first.
According to the Internal Revenue Code (IRC), any expense that is “ordinary and necessary” to keep your organization running is considered a justifiable business expense and arefully deductible in computing the tax liability of your organization. Expenses that are not ordinary and necessary are not deductible for tax purposes.
In recent years, we’ve seen many startups (tech companies in particular) spending a lot of their investors’ money to stimulate growth, all the while generating insufficientrevenue to cover their expenses.This idea that investing early on would help the business generate much larger returns further down the road has helped turn startups like Twitter, Facebook, Uber, and Netflix into household names.
Although this might be a good idea for small businesses that have the potential to grow with the influx of investor capital, it is a very risky approach. To avoid financial woes early on, most small businesses should start generating revenue from the get-go, whether or not they have investors backing them up.
Cash flow is perhaps the most important financial metric for startup owners, seeing as more than 80% of small businesses experience some problems with it within their first few years. In simple terms, cash flow measures the money moving in and out of your company’s bank accounts. Positive cash flow enables your business to grow and helps it obtain funding for additional growth.
To calculate your cash flow, you need to add up your total revenues and non-cash expenses, such as depreciation and amortization of tangible assets andstock and other non-cash compensation expenses, and subtract your total cash expenses for a given period. Another way to estimate cash flow for any periodis to add the following two numbers: (1) your organization’s net income for theperiod, and (2) the total amount of such non-cash expenses for the period. Ideally, your cash flow should be positive, and should be at least three to four times the amount of your organization’s total interest expense. Of course, this can be difficult to achieve in your early days, especially if you don’t have enough startup capital.
Maintaining healthy cash flow is essential if you want to take out a cash advance for your small business. After all, the cost of the cash advance must be covered sufficiently by your cash flow in order to persuadea potential provider of a cash advance that you will be able to repay the advance on a timely basis.
Accounts payable are the total value of outstanding bills that you have yet to pay. This short-term debt is shown as a liability on your balance sheet. To manage your cash flow successfully and avoid piling up debt, you need to monitor this metric carefully.
As a rule, many suppliers offer a sizable discount if you pay them early. If you manage to keep your accounts payable current, you will likely be able to afford to make early payments to suppliers. This, in turn, will allow you to save on some of your expenses, thus improving the cash flow of your business.
Accounts receivable arethe opposite of accounts payable – it’s the total amount of money owed to you by your customers for the services and/or products that you have provided them. Furthermore, whereas your accounts payable show as a liability on your balance sheet, your accounts receivable are listed as an asset. However, just because something is an asset on paper, doesn’t mean it’s an asset in reality.
You see, accounts receivable do not represent your actual profits but only the money that you are owed. If you fail to collect receivables in due time – or at all – what’s supposed to be an asset could easily disappear or be substantially reduced in value. For example, if you offer a customer a 30-day term to pay an invoice, yet it fails to do so before day 45, the 15-day wait could affect your cash flow in a negative way and you may lose some of the profit associated with the invoice. What’s more, getting customers to pay in the first place may prove difficult.
Just like you need to make sure that your accounts payable stay current, you need to do the same for your accounts receivable. If necessary, encourage your customers to stay current by offering them discounts for early payment, same as your suppliers offer you. That way, if they pay by day 15, you’ll have 15 more days until the end of your standard 30-day term to use that money to boost your profits.
To ensure that your small business is one of the 80% that survive their first year, you mustn’t overlook any of these five financial metrics. If you don’t have time or resources to do this, you can invest in software that automates some of these processes like accounts payable. Also, rather than keeping track of your finances all by yo