Entrepreneurs don’t usually like finance, and to some degree, it’s perfectly understandable. Many of them are so busy actually running their company that they never really understand the financial aspects of their business. However, this lack of understanding can lead to massive mistakes.
Even if you have a CFO (which you may not, depending on the size of your business), a successful business owner needs to have a basic understanding of certain financial and accounting principles. And the truth is that finance is less complicated than most entrepreneurs realize. Most of it boils down to a few key concepts, and if you master them, you tend to be in pretty good shape. T
he purpose of this piece is to identify these concepts and provide a basic framework for entrepreneurs to successfully manage their business’ finances. If you don’t know anything at all about accounting or finance, try to hone in on these three financial metrics and the concepts behind managing them successfully:
1. Cash flow from operations. There are three financial statements: the income statement, the cash flow statement, and the balance sheet. The cash flow statement shows how cash comes into the business and goes out of it.
For some reason, I’ve seen that many entrepreneurs tend to neglect the cash flow statement; this is truly inexcusable, given the crucial and rich data that it contains. There is one particularly important line on the cash flow statement, which is usually referred to as cash flow from operations.
Unfortunately, the term is not a uniform one; I’ve seen this term referred to in many ways: “net cash flow from operating activities,” “net cash provided by operating activities,” “cash flow from activities,” etc. Regardless of how it’s referred to, cash flow from operations = net income + non-cash expenses +/- the balance of changes in current assets and current liability accounts from the balance sheet.
Depending upon your level of financial knowledge, this may or may not sound complicated, but the idea is pretty straightforward. Cash flow from operations measures the amount of cash dollars a company generates in a certain period from its regular operations; it shows the cash that has come into and out of the company from normal activities. It does not include new loans or new investments or the sale of property or other financing or investing activities.
The beauty of this number is that it lets us know the cash that can be counted from the normal things a business is doing. As any experienced entrepreneur knows, the most important thing for a business, financially, is cash flow. It took me thirty years of experience (working at a bank, working as a consultant to entrepreneurs, running my own companies) to come to this conclusion, which is actually fairly obvious. If you understand the significance of cash flow from operations and guard it carefully, you’ll be way ahead of most entrepreneurs.
2. Net income margin. Net income margin = (revenues – all expenses)/sales. If you sell $100 dollars worth of product with expenses of $70, your net profit is $30 and your net margin is 30 percent. The margin is the percentage of profit we are earning on each sales dollar. This is another profound financial metric, because the margin, not the dollars of profit, measures the efficiency or safety of a business. This seems obvious, but it’s a very subtle point that is often overlooked.
Think of a business with $1000 in revenue and $100 in profit and a business with $500 in revenue and $100 in profit. Even though those businesses have the same dollar in profit, the second business has a much higher net profit margin and is a much safer business (assuming that all environmental variables are the same). Here’s why: if sales dip in company A, the company could easily fall into being unprofitable, because the expense ratio of that business is much higher. In company B, their sales could fall at an even greater rate and they might still remain profitable.
In this way, the net margin is almost like a proxy for insurance and risk management in an enterprise. It is a safety net. I wish more accountants and bankers understood and communicated this to their business clients, who are too often focused on revenue and profit dollars instead of margin.
3. Revenue growth. Think of revenue growth as a tool to service your net profit margin. Quite simply, more revenue coming into a business yields more cash to be splashed over expenses; therefore, revenue growth is obviously a good thing. If sales are decreasing year-over-year, that would be a warning sign. However, keep in eye as well on the rate of revenue growth that your business is seeing. If sales grew 100 percent from 2013 to 2014 and then 50 percent from 2014 to 2015, that might also give you pause. While 50 percent revenue growth is quite healthy, why has your rate of growth been sliced in half? This metric is fairly straightforward, but again, finance truly is not that difficult. If a business has positive cash flow from operations and a healthy net margin, and its revenue growth is positive, at least on a financial level, it is unlikely to fail.