This time of year, the bottom line many business owners are most concerned about is the one showing whether they owe taxes or are getting a refund. But as you finish your return or meet with your accountant to go over your tax return for the past year, it's a good time to learn more about your financial statements and consider whether your business is on track to make more money in the current year.
"I find that entrepreneurs are usually very good at the daily operations of their businesses, but understanding their financial statements is not as obvious to most of them," said Brian Hamilton, chairman of Sageworks, a financial information company. "You may be tempted to think about your financial statements only during tax time, but smart business owners will use their financial information anytime they are making a decision about their business."
Tracking business metrics related to your current and past performance helps in two ways:
- To improve current performance. Businesses often have a good handle on how sales are going, but expenses can easily creep higher and before you know it, your profitable venture isn't so profitable anymore.
- To develop the long-term value of the business that your plans require. One day, you may decide to retire or move, and you want your business to be worth as much as you think it is so that you can meet your personal goals.
The first step is to know which metrics can best help you gauge performance. It's easy to get bogged down by focusing on too many metrics or on metrics that have minimal impact to your bottom line.
Net profit margin, which drives the so-called bottom line, shows how many cents of profit is generated for each dollar in sales, and there's probably not a more important metric to show efficiency and your ability to scale or weather a slight sales decrease. Another profitability metric, gross margin, helps you identify when production cost increases are outpacing sales gains. Looking at that over several periods can flag the need to find efficiencies in production or lower costs by checking out new suppliers or re-negotiating with current suppliers. It can also help you weigh possible changes to your sales prices.
As its name implies, cash flow from operations, a line on the cash flow statement portion of financial statements, explains how much cash is being generated by the company's regular operations over a specific time period. Don't confuse profits with cash - if you've extended credit to your customers and they aren't paying in a timely manner, you could show strong sales growth and profits on the books and still be running short of cash to pay your own bills. Since lack of cash is often a primary culprit in companies going bust, which is a more important metric for your business - cash flow from operations or "likes" on Facebook?
Another reason to monitor cash flow is that eventually, your business may be judged on that metric if you decide to try to sell. "Often, the value of a business is largely dependent upon the company's ability to generate income," said Sageworks consultant Thomas Bryant. "Valuation may involve discounting projected free cash flows, capitalizing a benefit stream, or applying a market multiple to earnings. It's a lot easier to improve cash flow, for example, over time than to try to accelerate it in a single year or two."
Profit margins and other metrics, of course, can vary by industry, so some business owners use financial benchmarks to see how the company ranks against peers. Knowing whether your expenses relative to sales are higher than other firms in your geographical area can ensure you remain competitive. Certain industries also have key performance indicators (KPIs) that are of particular interest to them. Restaurants, for example, often, want to monitor sales per seat or what percentage of sales is for food vs. beverages.
Another benefit of looking at others in your industry is that prospective buyers typically compare a business to its peers to make sure they offer a fair valuation, so you'll want to know sooner rather than later how you stack up.
Ask your accountant to meet with you after tax season ends to explain to you in plain language the metrics that are most important to your business, and to help with any forecasting to gauge how 2014 is progressing. In the meantime, however, look at the metrics listed above and, if you have previous years' financial statements, look for trends. Jot down your questions so that you can have a more productive meeting.
Many private business owners are in the habit of thinking of their business financials in terms of limiting their tax liability, but that view really doesn't provide a full picture of the business's financial performance. For example, some expenses that aren't deductible for tax purposes (for example, professional licensing fees or federal income taxes) could impact profitability and should be evaluated as part of a financial statement review each year.