One skill that separates a financially intelligent business owner from an average entrepreneur is the ability to use financial indicators regularly to make timely, well-informed business decisions.
Surprisingly, many entrepreneurs look at financial reports only at year-end or even a few months later when financial statements become available. That lack of attention and proper financial management is putting their business at risk. As a business owner, you have to be disciplined in reviewing financial data at least once a month and conducting a more thorough analysis every quarter. You want to compare your company’s performance to objectives set out at the beginning of the year, based on a long-term strategic plan. You then make adjustments as necessary throughout the year to accomplish the objectives.
In this ever-changing business environment, it is critical that you make the right decisions at the right time. If you wait until year-end to address the issues, it will probably be too late. There are 4 types of financial indicators that you should monitor on a regular basis.
Growth indicator addresses a simple question – is the company growing? To use it you can apply the concept of trend analysis to provide insights about the speed at which a company’s revenue and profits are growing. It is also useful to compare revenue growth vs profit growth because a growing top-line revenue with a regressing profit could mean that the company is ineffective in managing operational costs.
Can the company meet its short-term obligations? Liquidity indicator aims to answer this question. If we say a company is liquid, it means a significant portion of its assets can easily be converted into cash. The ratio reflects the financial health of a company by comparing the company’s most liquid assets, or those that are most easily converted into cash, to short-term liabilities. The higher the ratio, the more likely it’ll be able to cover it’s short-term debt. A lower ratio suggests that the company may have trouble meeting short-term obligations and struggle to fund its long-term operations. The three liquidity ratio that you should monitor are current ratio, quick ratio, and operating cash flow ratio.
What is the company’s profit-generating ability relative to sales, assets and equity? It provides tremendous insights into the operational health of a company from multiple angles such as the company’s gross margin, operating margin, return on equity, and return on assets. You can use them to assess if your business is making enough profit compared to other similar companies.
Does the company have the ability to meet its long-term obligations? Businesses rely on a combination of owner’s equity and debt to finance their operations. The danger is that if a company finances a large portion of its assets with debt, it may run the risk of financial difficulty due to increasing interest expenses and the obligation to repay the loan. On the other hand, if you are not using any debt to run the business, you might not be taking full advantage of using external financing to operate and grow the business.
A word of caution about using financial indicators
It is important to remember that financial indicators need to be analyzed in the context of the business to provide accurate and relevant business insights. So having clarity over your business operation and the typical transactions performed by the company are critical.
We also recommend that business owners benchmark the financial performance of their business against that of similar companies in the same industry. Results that are below the average may highlight areas for improvement. For example, a below average gross profit margin indicates that you’ll likely need to reduce supplier costs, increase price, or a combination of both.
Entrepreneurs often work on intuition, but having the right information at the right time will help you make more educated decisions.