Our take on Finance 101 or less is about financial metrics and key performance indicators known as KPIs. Here are three rules on how to run your business successfully:
1. Manage your cash flow/Track and monitor all spending.
A business can fail for various reasons, but one is far more common than others—running out of money. Know where every single dollar is coming from and where every single dollar is going.
Warning: Ignoring your cash flow will put your business in a dangerous position. No matter how good your business is—zero money will pin you down and disable growth or even existence. Establish a budget and stick to it.
2. Every minute of your time has money value.
Time is money.
Nothing is more valuable than your time. Plan your schedule daily for day-to-day duties. Time spent on unrelated non-business is wasted time and money.
3. Establish financial goals.
Rule three is extremely important! Break down financial goals into reachable and measurable ones.
Monthly, weekly, or daily revenue goals can keep your business on track and allow for necessary adjustments to achieve constant growth. Compare your current budget with the actual numbers and make adjustments along the way. That should avoid negative year-end surprises or unpleasant calls from lenders.
Now let’s look at some crucial, basic numbers.
Key metrics that are vital to small business success.
Revenue is the amount of money your business takes in for sales of its products or services before any expenses are taken out. Revenue, also called sales or top-line income, is part of the calculation for most financial metrics.
Expenses are all the costs a business must cover to operate and earn revenue. With some exceptions, such as VC-backed startups, a business needs more revenue than expenses to survive. Examples of expenses are labor, equipment and supplies.
Let’s group expenses into two broad categories: operating expenses and non-operating expenses.
• Operating expenses are a direct result of doing business, like mortgages, production costs, and administrative costs.
• Non-operating expenses are more indirect and include interest and other lending fees.
- Net Income
Net income or net profit is the money left over after subtracting all expenses and taxes from revenue or Expenses – Taxes = Revenue.
Most small businesses need to bring in enough revenue to cover their expenses. If they don’t, they risk falling into debt and eventually going out of business. (Exception: investor-backed startups that lose money.)
Note: Net income is also referred to as the bottom line because it shows up below revenue (the top line) on profit and loss (P&L) statements.
- Cash Flow/Operating Cash Flow
Cash is the lifeblood of small businesses—they rely on the money coming in to pay expenses. Cash flow is the amount of money moving in and out of a business over a certain timeframe. For example:
• positive cash flow is more money coming in than going out. That business has positive cash flow.
• negative cash flow is if a business is paying out more money than it’s receiving.
That is negative cash flow.
- Working Capital
Working capital is the difference between current assets (cash, accounts receivable, and short-term investments) and liabilities (accounts payable, payroll, taxes, and debt payments).
Current Assets minus Liabilities equals Working Capital
This metric helps to paint a picture of a business’s financial state for the near term by looking at its available liquidity to cover immediate expenses.
- Budget vs. Actual
Just as it sounds, budget vs. actual compares a company’s actual spend or sales in a certain area against the budgeted for amounts. Although budgets and expenses are related, budget vs. actual is often used to compare both revenue and expenses.
This budget variance analysis helps small business leaders identify areas of the business where they’re overspending that may need further attention. It also reveals areas of the business that outperformed expectations.
- Accounts Receivable Aging
Accounts receivable aging is a report that measures how many days it takes your customers to pay their bills. Companies often include credit terms on an invoice that say how many days the customer has to submit payment; 30 days is common.
On an accounts receivable aging report, a business typically organizes clients by due date for reference—immediately, 1-30 days late, 31-60 days late—to see how much money is collectible from different companies and timeframes.
- Gross Profit Margin Ratio
Gross profit margin ratio shows revenue after deducting the cost of goods sold (COGS)—that is, the direct costs of making a product. This ratio, written as a percentage, reveals the gross profit for every dollar of revenue a business earns. A ratio of 60%, for instance, means the company receives 60 cents of profit for each dollar of revenue.
- Average Customer Acquisition Cost
Average customer acquisition cost uncovers how much a company spends, on average, to add new customers during a certain period of time. This metric factors in expenses for marketing, technology, payroll and more. Customer acquisition cost is typically proportional to the price of a product or service, so it varies widely by industry—the average retailer spends $10 to acquire a customer, while the typical technology provider shells out $395.
An organization can compare customer acquisition cost to customer lifetime value to ensure its business model is sustainable. If necessary, a company can lower its customer acquisition costs by reducing marketing spend and focusing on customer retention and upsells.
- Cash Runway/Burn Rate
Cash runway calculates how long a company has before it runs out of cash based on the money it currently has available and how much it spends per month. This metric helps businesses understand when they need to cut back on spending or get additional funding. If your cash runway shortens over time, it’s a sign your company is spending more money than it can afford to.
Cash runway is closely tied to burn rate, which measures how much money a company spends over a certain period (usually monthly). Burn rate is frequently used by investor-backed startups that lose money in their early days.