By regularly reviewing certain financial indicators, owners of small businesses can better identify potential issues and determine if their companies are on a growth path. Here are four financial indicators that can reveal much about the financial health of a small business.
Cash Flow
Cash is critical to the functioning of every business, regardless of size. You should be concerned if your cash flow is insufficient to cover expenses because payments are coming in slowly.
Understanding the cash conversion cycle can help you effectively manage cash flow. A typical cash conversion cycle runs from the initial purchases of inventory, to selling the inventory, and, finally, to receiving payment for the sold inventory. Your goal should be to keep the cash conversion cycle, which is measured in days, as short as possible.
Revenue Growth
The revenue growth rate measures how well a company is able to grow its sales revenue by comparing current sales figures (total revenue) with a previous period, usually quarter to quarter or year to year. Be sure to review monthly or more frequent reports summarizing sales and year-to-date results by sales category. While short-term fluctuations are to be expected, a consistent decline in revenue is a signal that your business could be in trouble.
Profitability Ratios
Various profitability ratios measure a company’s ability to generate earnings from sales, operations, assets, and shareholders’ equity. For example, gross profit margin is the amount of total revenue remaining after subtracting the cost of goods sold, expressed as a percentage of the total revenue. Return on assets is net income divided by total assets. You should monitor profitability ratios over time so that you are aware of trends and can take appropriate steps to enhance your business’s profit levels.
Break-Even Point
The break-even point is the sales level needed to cover costs. Determining a break-even point lets you evaluate the potential effect of various price and cost assumptions on your profits. You can analyze the potential effect on your business’s profitability if you increase or decrease fixed costs, variable costs, or selling price. In general, it is better to keep your fixed costs as low as possible to minimize potential problems if your sales levels fail to meet your targets.
An experienced financial professional can assist you with your business strategy and planning and can help you analyze key financial indicators to inform your decision-making.