As the year draws to a close, many small business owners are taking stock of their business, basking in their successes and trying to comprehend their mistakes. Unfortunately a big picture view does not always immediately reveal itself– a thorough understanding of your business requires at least some analysis and introspection. You may be tempted to look at cash (or lack thereof) in your bank account or your net profit , however these are not always reliable indicators of success or failure , particularly when taken in isolation. Every small business owner should identify the specific needs and constraints of their business to determine the optimal analysis required to assess its financial performance. Some general analysis that most businesses can benefit from are presented below:
Profitability: Compare your current year profit to the prior year and calculate your net profit as a percentage of sales for both the current and prior year to see if you are maintaining or improving upon your financial performance. Ensure that you reflect the following Adjustments:
- Salary Adjustment: If you, as the proprietor, did not take a salary, you should reduce your profit by a reasonable estimated salary that takes into account the amount of time you spent at your market rate. Similarly, if you are getting any breaks eg. You don’t have to pay rent because your father in law owns your premises, then you should reduce your profitability by the market value of the perk.
- Bad Debt and Inventory Writeoff: Ensure that you reflect bad debts i.e. amounts from deadbeat customers who are probably not going to pay (no matter how hopeful you are) and reductions in inventory for items that have gone out of style, are obsolete or just not selling.
Gross Margin Analysis: If you sell products, your gross profit margin is an important metric that should be compared to your own historical rates as well as to the industry standard. Gross margin is essentially determined by taking your net sales and deducting direct costs like materials, direct overhead and labour, tools etc. A great deal of information can be gleaned from this number in terms of optimum pricing strategy.
Return on Investment:An extremely important calculation, particularly for proprietors who have invested capital into their businesses, is to determine the net profit as a percentage of the invested amount (ROI). This communicates the return that you are receiving on your investment, which should then be compared to the return that you could get on another type of investment. Imagine you are a cafe owner that has invested $100,000 into your cafe. Your ROI at the end of the year is $10,000, which translates into a return of 10%. Assuming that you pay yourself a reasonable salary (already reflected in the expenses), 10% is a decent return on $100k considering you would probably get a lot less in a savings account or even the stock market (keep in mind that running a business has a high premium for risk, as it is easier to lose some or all of your investment,so 2% in a savings accounts might be equivalent to 10% in a business). Alternatively, if your return is only 5%, it might be time to re-evaluate the business as, considering that you are getting a pretty low return for a high amount of risk. Clearly there are many other factors to take into consideration, but this is a good starting point.
Cash Flow Analysis: You might find that you are profitable; however your cash flow is tight or negative. This could be due to several factors:
- High levels of accounts receivable i.e. customers who owe you money. This means that, although your sales are high, your collection rate is slow thereby reducing your cash flow.
- You need to maintain high inventory levels to ensure that you are able to meet customer demand. This could mean that you are tying up too much of your free cash flow in inventory.
- Although customers pay slow, your suppliers require that you pay quickly thereby creating an imbalance between amounts received and paid.
There are an innumerable number of analyses that can be done to measure the financial health of your business, but there are only so many hours in a day and only so much that any one person can look at numbers without it all becoming a little bit meaningless. As such it is important to identify the areas of your business that need to be examined and review them on a regular and timely basis.
Ronika Khanna is a Montreal Accountant who helps small businesses analyse their operations. Please sign up to receive articles pertaining to small business, accounting, tax and other occasional non business topics of interest. You can also follow her on Facebook or Twitter.