Your cash flow metric is one of the most important financial numbers any small business owner should track.
One of my closest friends is a CPA who, years ago, used to regularly ask me about how my business was going and tried to offer advice. At the time, I thought I knew more about running my business than he did and thought his accounting advice was nothing more than accounting mumbo jumbo. It took me a while to appreciate the value of his advice—which I admittedly had to learn the hard way.
Do You Have a Profit Expert?
He argued the profit expert was a very important role and critical to building a profitable business. This expert is often the small business owner, but not always. The profit expert understands the accounting function (but isn’t necessarily an accountant), can glean important insight from looking at many common financial reports, and can make (or help make) decisions based upon what the financial information is revealing to them about the health of the business.
Cash Flow is the Life Blood of Every Business
It didn’t take very long to appreciate the value and importance of understanding how the cash flowed in and out of my business. I originally believed, that if there was cash in the bank, I was profitable. I didn’t understand that cash in the bank and profitability were two very different things.
I understood that without cash flow, business operations can come to a grinding halt and that over the years, poor cash flow (or poor cash flow management) has led to the death of many small businesses. One of the metrics we used to discuss was what he called “The Cash Flow Metric.”
If the profit expert understands anything, he or she understands how the cash flows in and out of the business.
Do You Know Your Cash Flow Metric?
If this is something new to you, it’s definitely something you need to become more familiar with. Because 82% of small businesses fail because of poor cash flow management skills, this is probably one of the most important metrics to understand.
Your cash flow is easy to understand and calculate that will give you actionable insight into how your business is performing financially.
Your cash flow (or working capital) is your assets minus your current liabilities.
Current assets include
- Cash in the bank
- Current Accounts Receivable
- Business location (if you own it)
- Any other equipment or other asset you may have to facilitate doing business.
Your liabilities include:
- Current Accounts Payable
- Business loans
- Line of credit
- Other business debt
- Other long-term payables
If you divide the value of your current liabilities into your current assets, you’ll come up with a ratio of assets to liabilities. The optimal ratio will be 2:1, or twice as many assets as liabilities.
Although this ratio is difficult for many small business owners to achieve, any ratio below 1:1 should be considered a red flag and indicates that it costs you more to run your business than you receive. In other words, you are not profitable—even if you have cash in the bank at the end of the month.
Addressing a Weak Cash Flow Metric
Strengthening your cash flow metric isn’t really very complicated but does take effort. Your accountant would likely welcome the opportunity to sit down with you and create a more detailed strategy, but here are three tasks you can start to address a cash flow problem:
- Categorize your spending: This is one area where your accountant should be able to help you. Some expenses help you generate income, like purchasing inventory or business critical equipment. Other expenses may be more overhead related, or less directly attributed to generating income, like purchasing paper supplies, bathroom supplies, and the lease on your building. Your accountant will also be able to help you with some rules of thumb for how much of your revenue should be devoted to categories like marketing, operations, sales, etc.
- Benchmark your current spending: Once you’ve categorized your spending, you should monitor your spending habits to make better-informed decisions about where you should be.
- Micromanage your spending: Every dollar you spend is either increasing your potential profits or detracting from your profit margin. As a result, it’s important to consider the costs and benefits of every expense. Controlling expenses is a powerful way to impact your bottom line.
We often positively impact the issues we pay the most attention to. For a business owner, paying attention to the cash flow metric should be at the top of the list.
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