There are traits that entrepreneurs often have in common, traits that make them the type of people that don’t just have an idea, but act on it: drive, creativity, and a sense of vision, to name a few. A strong understanding of finance, however, isn’t always one of them. I’ve known many business owners that make the best widget or provide the best services in the world, but don’t know what their financial information is telling them, or, in turn, how to make decisions based on that information. I’ve seen this lack of financial understanding become a deterrent to the growth of many businesses and an accelerant to the failure of others.
If you’re bootstrapping or working on a budget, the expertise of a CFO may not be a luxury you can afford. Even if you’ve successfully scaled your business, knowing a few core financial principles is essential as you continue to grow. Below are four pieces of financial knowledge that, even if you know nothing else, can help you keep a pulse on your company’s financial health and make better, more informed business decisions.
Know Your Net
Net profit margin is the single most important financial metric. A company’s net profit margin indicates the amount of profit a company makes for each dollar of sales. Net profit margin, expressed as a percentage, is your company’s net income divided by sales. Consider this metric to be an insurance hedge: it shows the ability of a company to still be profitable if dollars of profit decrease. Amazingly, it is an overlooked metric, even when analysts are evaluating public companies. If nothing else, just knowing, tracking, and guarding this metric would make most companies very successful.
Let’s say Company A has $100 in sales and $20 in profit. Company B has $200 in sales and $30 in profit. You might look at these two companies and say Company B is healthier, since it has higher sales and more profits. However, you have to dig deeper. In this case, the net profit margin tells the story: Company A has a 20 percent net profit margin and Company B has a 15 percent net profit margin. In other words, Company A is more efficient, getting 20 cents out of every dollar of sales. In turn, Company A may be easier to scale and less vulnerable if sales drop slightly. It’s likely that Company A could see sales fall more than Company B and still remain solvent.
Think (Cash Flow) Positive
Positive cash flow can free you up to think strategically. The “cash flow from operations” line on the cash flow statement shows, somewhat intuitively, how much cash is going into a company from regular operations for a certain period of time. If you do not have positive cash flow, you will not be able to pay your bills, or, worse, you’ll always be worried about whether you have enough cash. When you’re worried about cash all the time, your number one priority is survival. Positive cash flow frees you up to think strategically, instead of just thinking about how you’re going to keep the lights on. When companies go under, lack of cash flow is often the primary culprit. This all may seem obvious, but in my experience in working with many companies, few have a healthy command of cash flow.
Also, keep in mind that a lot of companies equate profit with cash, which is almost always wrong. Contrary to popular belief, a company could be profitable and still not be generating positive cash flow. Consider a company that sells $100 in products, but all the sales are on account. In this case, the company doesn’t collect cash; instead, it has generated $100 in accounts receivable (AR), a non-cash asset on the balance sheet. Even though you generated $100 in sales, you didn’t receive any cash for those sales. As an aside, my personal preference would be to never have an AR policy and to have all cash/credit card/debit/check sales. Too many companies give credit to their customers automatically without really understanding the consequences of doing so.
You might not be ready to borrow. When I started out in business, I borrowed money much too readily, before my business models were really proven. Here’s the central problem with borrowing money: it needs to be paid back every single month, independently of how your business is doing. This is a bit of a truism, but if you don’t owe money, you can’t go bankrupt. I have no problem with borrowing money to expand a proven business model. When you know your business model is working, aggressive expansion through borrowing might be a great thing. However, my experience is that entrepreneurs pull that trigger too early and when companies borrow too early, they are often saddled into making short term decisions that are based on cash flow constraints, instead of long run, strategic decisions that can make them very successful. It’s the same scenario described above: when you’ve taken on too much debt, your decisions are aimed at survival (making the next payment), not the long term success of the company. It’s up to you to figure out whether borrowing is in your best interest. Personally, I can think of no good reason for a startup to borrow money. Almost any startup business can and should be bootstrapped.
Look for Ways to Leverage Sales and Profit
Know how your people, assets, and debt leverage sales and profit. This one is a little bit more abstract, and harder to describe. I’m always trying to figure out which resources and activities leverage sales and profit the most. In finance, there are only a few things that we really manage and control: people, assets/“stuff,” and debt. I always like to look at and evaluate the relationship between A) how much I increase people, debt, assets/stuff and B) the impact on profits and sales. So, for example, if we increased our payroll expense by 10 percent last month, what did revenues do and what did profits do? Try to compare the rate of change for one of these factors against the rate of change in sales and profits. This may seem like an academic point, but it’s not. If we bought a piece of equipment, we would hope that sales or profits have gone up with that piece of equipment. If you added 10 percent to payroll, you’d hope that revenues increased more than 10 percent from that type of move. There are formulas you can use for this, but really, it’s all about getting people to think critically about the things they manage and the impact of those things on sales, profits, and cash. This is simply common sense applied in a financial context. When this is done the right way, it isn’t just done on specific important decisions; it’s done regularly, in aggregate to measure every decision made at the company.
Getting a good accountant to help with all of this is recommended. Many accountants view their role as just helping with bookkeeping and tax preparation, but a good accountant should help you run your business.