Taking the temperature of your small business's financial health

If you can’t produce three years’ worth of data, produce however many years you can. You can always use quarterly information if years aren’t available. Unless your business is seasonal, quarterly information can suffice.

Just glancing over the statement often reveals areas to investigate, such as sales steadily declining or expenses drastically rising. But to discover if your profitability is sound or sick, you’ll want to calculate your gross profit margin.

To determine the gross profit margin, divide your net income by your gross profit (net sales).

Example

Consider these three years’ worth of data.

Our gross profit margins (net income divided by gross profit) for each year are as follows:

• Year 1 — 0.6 (60%)
• Year 2 — 0.58 (58%)
• Year 3 — 0.54 (54%)

While these gross profit margins are very high, they are trending down. And, as you probably noticed, the year with record sales did not boast the highest gross profit margin ratio.

Monitor these ratios closely to ensure your margins remain steady or, hopefully, increase. When it comes to your gross profit margin, you can abide by two universal truths:

• without effort, your sales will likely decrease
• without question, your expenses will likely increase

If your margins are slipping, or fall within an unacceptable range, remember the trick isn’t always boosting sales. If a boon in sales also results in a boon in expenses, nothing has improved. The key is to raise sales while stabilizing or decreasing expenses. That may sound like a pipe dream, but you can curb expenses by taking measures such as:

• cancelling service contracts that add no value
• outsourcing services, especially ones that currently keep you from growing your business
• calling current vendors to ask for reduced rates (it does work!)
• implementing no-cost social media marketing and advertising programs

Leave no stone unturned as you investigate ways to cut expenses and increase sales. Don’t be afraid to question the necessity of anything. Asking tough questions about the status quo is, after all, what makes you an entrepreneur.

4. Investigating your inventory

Many small business owners err on the side of maintaining (far) too much inventory. This strategy might make for happy customers who never have to worry about anything being out of stock, but it demands a great portion of your cash flow.

To keep your inventory at the right level and improve you cash flow, calculate these helpful ratios:

• the average inventory investment period, which shows time needed to convert a dollar of cash outflow, used to purchase inventory, to a dollar of sales or accounts receivable
• the inventory-to-sales ratio, which focuses on your investment in inventory in relation to your monthly sales

Average inventory investment period. The first step to evaluating the financial health of your inventory lies in the average inventory investment period. Here you can see the average time needed to convert the money invested in your inventory into what you really want: sales. To find this investment period, you’ll need to divide your present inventory balance by your average daily cost of goods sold. If you don’t know your average daily cost of goods sold, simply divide your annual cost of goods sold by the number of days you’re open annually.

Example

If, over the course of one year, your business sold off inventory for which you paid $113,500 and was open 355 days (closed for 10 holidays), your average daily cost of goods sold is $320. If your inventory balance remaining at the end of the same year was $37,000, your average investment period is 116 days.

• Average daily cost of goods sold — $113,500 / 355 = $320
• Average inventory investment period — $37,000 / 320 = 116 days

You might be thinking 116 days seems like an awfully long time before that money spent on inventory turns into sales. If so, you’re on the right track. Any steps you can take to reduce the number of days in this period results in more cash flow. If you ordered less to the point where you could reduce your inventory balance to $26,000, your average inventory investment period would drop to 81 days and add $11,000 into your cash flow. That may be a lofty goal, but remember that any inventory you can delay ordering without affecting your customer experience is a positive step toward a reduced average inventory investment period.

Inventory-to-sales ratio. Unlike the average inventory investment period’s focus on the past year’s events, the inventory-to-sales ratio reveals your recent monthly inventory trends. To calculate this ratio, use x:y, with x representing a month’s inventory balance and y its total sales.

Example

If your business maintained a $15,000 inventory balance (x) at the end of June and earned $10,000 in sales (y), your inventory-to-sales ratio is 3:2.

Of course, this ratio, out of context, doesn’t offer any insight. But when tracked on a monthly basis, it can shed light on inventory trends. Be wary of an increase in this ratio, as it means one (or both) of the following is hurting your business:

• your investment in inventory is growing more rapidly than sales
• your sales are dropping

As you calculate this ratio on a monthly basis, look to see if you need to start ordering less or finding ways to spur your sales.

5. Assess your debt levels

Risky Business isn’t just a Tom Cruise movie. You must weigh the financial risks of your decisions every day, especially when those decisions involve increasing your debt load. To see what new debt obligations will mean for your business—or to see if your current ones are acceptable—you can calculate a series of solvency ratios. The two most important, though, are your debt-to-equity and debt-to-assets ratios.

Debt-to-equity ratio. Once you have your balance sheet, you can determine your debt-to-equity ratio of x:y, with x representing your total debt and y your equity in the company. If your business owes $100,000 in debt (x) and you possess $25,000 in equity (y), you have a debt to equity ratio of 4:1.

Like many of the previous examples, the lower the ratio, the better. If your ratio level rises over time, you’ll need to find a way to curb its growth. It might just be a matter of adjusting the paperwork, such as deferring expenses or bonuses beyond the balance sheet date if possible. If you are able to use cash to pay down debt, it might be a good option. Besides having your business look better on paper for potential investors, a low debt-to-equity ratio gives you more flexibility to expand as the opportunity arises and take on more debt as the need surfaces.

Debt-to-assets ratio. You can find your debt-to-asset ratio with x:y, with x representing your total debt and y your total assets. If your business owes $100,000 in debt (x) and you possess $50,000 in assets (y), you have a debt to asset ratio of 2:1.

Maintaining a debt to asset ratio of 2:1 or lower is your best bet. Anything higher can result in difficulties making your debt payments. To lower this ratio, your options are admittedly a little limited. You can pay down your debt and explore ways to increase the value of your assets, such as improving your facility (if you own it) or having your inventory appraised. The latter, though, may backfire and decrease the value of your assets.

While all these steps will help you run your business more profitably and efficiently, they will also be instrumental in improving your odds for receiving a loan and helping you plan your business strategy. But as helpful as these tools might be, they will change as your business changes. You’ll need to re-evaluate them regularly, at least on a quarterly basis. Don’t wait until your business is in dire straits before taking its financial vitals.