According to statistics from The Small Business Administration, about half of all small businesses don’t survive to reach their fifth birthday. Economic analysts and fellow entrepreneurs will speculate as to why, but at least one factor of this low success rate is that many business owners don’t understand their financials. A baker who launches a local cupcake shop may only be familiar with the math needed to perfect their vanilla buttercream. That’s why that baker needs a CPA in their corner — – just as the dentist, the bookstore owner, the photographer does.
Many small business owners may think revenue is the only financial metric that matters, and certainly, sales greatly affect many other metrics on an income statement. But in order to keep your business afloat, there are several additional metrics that are important to understand. Jot down some notes before your next appointment with your CPA to make sure these metrics are top of mind, and don’t be afraid to ask for context to help you get a firm grasp on the numbers.
1. Pre-tax net profit margin. How much profit is your business making for every dollar in sales? This metric is an incredibly important one, as a higher margin equals more profit. Speak with your CPA about this figure in terms of business expenses – is there an opportunity to cut costs in some areas? Managing expenses effectively is one way that many small business owners can almost immediately impact profits in a positive way. Most accountants have assisted a wide variety of companies over the years, so they will likely have ideas you may not have considered.
2. Current ratio. Current ratio is the proportion of current assets to current liabilities – essentially what assets you can convert quickly into cash (usually within a year). A current ratio under 1 suggests that a company would be unable to pay off its short-term debt obligations.
Current ratio is the proportion of current assets to current liabilities – essentially what assets you can convert quickly into cash (usually within a year). A current ratio under 1 suggests that a company would be unable to pay off its short-term debt obligations.
3. Quick ratio. Quick ratio evaluates the ability of a company to meet those same obligations with its most liquid assets – cash plus accounts receivable. Inventory is excluded from assets used to determine the quick ratio because inventory isn’t as liquid as cash or receivables. As with current ratio, the higher the quick ratio, the better positioned the company.
While these are two individual ratios, they are generally analyzed together to help show a more complete picture of a company’s liquidity. The reason these two metrics are crucial to understand is actually a very simple concept – without adequate liquidity, one unexpected expense can cripple a small business.
To better understand all three of these metrics, it could be helpful for your CPA to offer industry benchmarks. Because industry financials are often unique, seeing how your business sizes up against others in the same field can best explain where your business needs to be. Whether you’re the baker who knows only a little about financial statements, or an independent executive consultant with more than a dozen years’ experience, utilize the time you have with your CPA to understand why it takes more than just dollars and (business) sense for your business to see it’s fifth – or 25th – birthday.
Our CPA firm specializes in helping small business owners to understand their financial statements and to analyze their business to make wise financial decisions. For more information, please visit us on the web at http://www.LStortzCPA.com