Small business owners may one day feel confident and unstoppable; at the top of their game. Then the next day, they may pull a financial report on their business and feel their head spin. Doubt may creep in. With so many metrics to pay attention to, they might feel overwhelmed and shut their laptop, hoping to give it a shot another day.
If this sounds like you, read on.
Colleen Pratt Sarihan, founder of The Crew Consultants, who helps business owners use data to solve problems, believes that financial literacy doesn’t have to mean looking at everything.
“It means taking a step back and deciding what numbers are meaningful for your business — and understanding the levers you can pull to maximize your time, talent, and resources,” she said.
We’re going to start small. If you only pull financial reports once a year for your tax accountant, you are missing out on some powerful tools. Now that Q1 2021 has ended, you have 3 months of data to spot trends. Plus, given that April is financial literacy month, there is no better time to get started than today.
Here are 5 metrics you can pull right now to gain better insight into your businesses’ financial health.
1. Start with the end in mind
The most crucial report to assess your financial health is a profit and loss (P&L), which is often found under the “Reports” tab of your accounting software. Too often, though, business owners get laser focused on the top number of their P&L: Total (Gross) Income. Hustling to bring in sales becomes their No. 1 goal. But revenue, while important, is only half of the equation, said Steve Kampschmidt, CFP, Founder & Advisor of Freedom Found Financial.
He advises that clients start not at the top of their P&L, but at the bottom: with net profit. “This is the number that matters,” he said. It’s the money you have left after all expenses and costs are subtracted from revenue. It’s the money you have left to pay yourself a salary, save for emergencies, or put back into the business.
Without it? Simple. “You don’t make money,” he said. “Business owners may start to bring in revenue, get excited, and think it’s okay to increase spending or hire staff,” Kampschmidt said. The problem arises “when everything that’s coming in the front door is going out the back door,” he continued. “It’s better to take a bootstrapped approach and do things in an efficient way. Then as net profit starts growing, consider increasing expenses.” Business owners with money in the bank tend to be proactive rather than reactive, he added.
To find your net profit margin, pull your P&L report and scroll to the bottom of the report to find net income. Next, divide net income by total revenue for the same time period and multiply the result by 100 to create a percentage. That’s your net profit margin. Ideal margins vary widely by industry and company size, but as a general rule of thumb, a 20% net profit margin is considered good, a 10% margin is considered average, and a 5% margin is low.
2. Identify the bucket that’s eating your budget
If your net profit is low or money feels tight each month, you’ll need to cut expenses or find efficiencies. How can you diagnose the problem quickly? First, take a step back and think holistically about the top three “buckets” you want to track or feel are taking the largest chunk out of your income. Then, pull a P&L report and make sure your list of account categories are not too split up that they fail to provide meaningful insights.
“You can be creative and structure your data in a way that makes sense for your business and the decisions you need to make,” Pratt Sarihan advised. One of her clients, for example, owns a studio. At first, those expenses were spread out across her reports in separate categories, such as rent, utilities, and cleaning supplies. The client wanted to know: How much does the studio cost us to run, as a whole? In response, Pratt Sarihan created a larger bucket called “Studio Costs” and grouped all of the sub-categories underneath. That way, studio costs rolled up into one larger number, and its financial impact on the business became much more apparent.
In your accounting software, navigate to your Chart of Accounts, which is your central list of accounts. This list may look familiar: these are the options you are given to choose from when categorizing transactions, and you can edit their names and structure as needed. In most accounting software, you can edit these categories to make any expense a “sub-account” of another category. Once you group a set of expenses together into a larger “bucket,” you may find, for instance, that 50% of your expenses are going toward one area. You’ll then have clarity on what area to get started on reducing costs or finding efficiencies.
3. Discover whether your business is too reliant on one customer or industry
Does one client make up more than half of your business? And do you know the answer to that? This is a crucial metric — and one you can find right now.
Log into the software you use to track your customers and invoices, whether that is your accounting, invoicing, or point of sale (POS) software. Find the Reports tab and search for a report called Sales by Customer or Income by Customer. Using this report, divide the total sales from each customer by the total sales from all customers within the same time period. Does one client make up more than 60% of your business? If so, it’s up to you to decide whether that makes sense for your company or makes you vulnerable to shifts in trends or relationship dynamics. “It’s nice to have some ‘anchor’ clients,” Pratt Sarihan said, “but you don't want too many eggs in one basket. It’s better to have diversity from a customer and industry perspective.”
4. If Sales stopped tomorrow, what costs would you still need to cover?
The pandemic made the importance of this metric apparently clear: If sales stopped tomorrow, how much does it cost to run your business each month? To find this metric, pull your P&L report, and look for the line called “Total Expenses” or “Total Operating Expenses.” These are expenses you generally have to pay month to month, regardless of how your business is doing. Ask yourself, “If I did not make a single sale this month, would I still have to pay this expense?” Costs such as rent, insurance, utilities, and payroll are a “yes,” so they fall into operating expenses. On the other hand, cost of goods sold (COGS) do not count because they are costs tied to sales; as sales decline, these costs tend to decline as well.
Getting a hold on your monthly set operating costs tells you two things. One, you now know the bare minimum amount of sales you need to make each month in order to stay in operation. And second: many accounting professionals suggest keeping 3 to 6 months of operating expenses in savings in case you have an unexpected lag in sales. Set a target to build up this amount (multiplied by 3 or 6 depending on your goal) into a savings account as an emergency fund.
5. Focus on a project's profitability rather than its price tag
Do you know whether you are charging enough for your services? The best way to find out is to create “mini P&Ls” by project, explained Pratt Sarihan. That means tagging each expense to the project you purchased it for so that you can track both revenue and expenses on a single project. What clients discover can be eye opening, explained Pratt Sarihan.
“Sometimes projects with the biggest price tag aren’t necessarily the most profitable,” she said. “They might be the most costly for you to execute from a labor and materials perspective.” It’s easy (and tempting) to only go after big invoices, she continued, but if they are the most time and labor intensive “you are better suited having a mix of projects, including some that are faster and easier to execute.”
In most accounting software, you can link income and costs to a particular project, using project tracking, classes, tags, or other customized labels. That means that in addition to designating an expense as supplies or meals, for example, you can also select what project that cost was associated with. Once you categorize every expense by project, you can navigate to your Reports tab and pull a Profit and Loss by Project or Project Report to see the net profit from each job. This will help you determine which jobs went over-budget or assess whether your price point needs to be adjusted.
*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.