How to Measure The Financial Health of Your Small Business
There comes a time in every small business’s life when wondering about financial well-being no longer remains a viable option. To successfully develop your business, you need to know whether or not it’s healthy. Increased sales, growing popularity, and busier operating hours are all wonderful signs, but without the help of financial performance metrics, you’ll have a difficult time gauging sustainability.
In our opinion, there are four key financial performance metrics that every small business should pay attention to. These five metrics will assist you in assessing the foundation of your business and aid in planning for future growth. Let’s walk through them and explore some cases.
1. Profitability
At the core of any successful business is the ability to remain profitable. Having enough money each month to cover employee wages and other business expenses is great, but without a proper understanding of true profitability, it can be challenging to assess overall status.
Your business profit is found in your income statement and assessed in both gross and net forms. As a business owner, you should be reviewing monthly, quarterly, and annual changes to profits, as well as comparing them to months, quarters, and years past. This review will help you understand business development and determine whether or not you're on a trajectory grounded firmly in profit.
If you’re noticing that profits are increasing over various periods, do more than just celebrate. Explore which drivers are causing the growth and determine whether or not more can be done to improve focus on them. If you notice that profits are decreasing, explore the causes and work towards putting corrective measures in place.
2. Gross Margins
Pulling from the income statement once more, gross margins are a performance metric that will offer insight into how well your company uses its resources to generate revenue. By taking the total revenue generated and subtracting any costs associated with producing it, gross margins will tell you whether or not your operational structure is sustainable. As with profitability, you’ll want to compare gross margin trends over various periods. Increasing gross margins will show that you’re operating more efficiently and are generating more revenue per dollar spent. Decreasing gross margins will highlight the opposite, shedding light on a need to lower production or labour costs to maintain long-term profitability.
3. Growth Rate
Obtaining a holistic growth rate measure for your business is easier said than done. However, it does need to be done. We’d recommend looking at trends to your sales revenues, net profits, working capital and free cash flow, and customer base size as good indicators of overall growth. Although each of these items has complex layers leading to the final figures, assessing change in the final figures can be a wonderful way of quickly gauging business health and trajectory.
As a side, it’s these growth metrics that will allow you to forecast the future accurately. By taking past growth and running it years into the future, you’ll be able to predict revenues, expenses, and more, having the ability to plan and prepare for what’s ahead.
4. Burn Rate & Run Rate
Your burn rate and run rate are wonderful metrics for monitoring cash health in your business and determining whether or not future obligations can be met comfortably.
Your burn rate looks at the depletion of your company’s cash pool in a loss-generating scenario. It will help you understand your ongoing cash obligations, and whether or not you’re able to cover them into the future if revenues were to falter over time.
On the other hand, your run rate is the forecasting of future spending based on current expenditures. To obtain an accurate run rate, you’ll look at spending totals over the last few months, quarters, or years and project them forward using a standard growth rate. Calculating a run rate is essential because it will allow you to predict future cash obligations. You’ll then be able to look at current cash flow generation and cash on hand to determine whether or not you’re capable of meeting these obligations. If the answer is yes, you’re in good shape. If the answer is no, you’ll need to adjust accordingly to prevent a cash crunch from damaging your business stability.
Closing Thoughts
As your business continues to grow, it’s important to make decisions using financial and performance information that is updated and accurate. Much of what we talk about in this article can be found scattered across your core four financial statements, in addition to the help of a few simple equations. If you’re unsure of where to get started or where to go now that you’ve taken a deeper look into your company’s performance, our team is ready to help. Get in touch with us today to learn more about how we help small businesses build better!
