You’ve probably had a moment or two when you thought, “How do I know if I’m on the right track? Is my business okay?”
Like when you were paying bills and noticed things were getting a little tight in your business account.
If you do a regular pulse check of your business’s financial health, you won’t have to vaguely stress about how things are going. You’ll just know.
Here are seven questions that’ll help you identify your company’s financial health so you can build a business that everyone and their rich uncles wants to buy.
1. First, how are your profits?
Booming sales don’t actually tell you much. You need to look at profit.
You can find out how much money your business brings in after bills by subtracting your operating costs from your total revenue. But skimming through your financial statements and looking at your profit isn’t a good way to assess the financial health of a company—it gives you one small piece of a much larger pie.
2. How much are you spending on inventory?
You’ve got to spend money to make money.
By looking at your cost of goods sold (COGS), you can see just how much money you need to spend to keep your money-making machine going strong.
COGS is the cost your business spent acquiring or producing items that you’ve already sold to your customers. By itself, it may not seem like a big deal—but when combined with other business metrics in your financial audit, COGS can help you:
Find your ideal pricing structure
Gain a bigger picture of your company’s overall financial performance
Assess the profitability of your products
Here’s how to calculate COGS:
COGS = Beginning Inventory + Inventory Purchases – Ending Inventory
From here, you can use this number to calculate your gross margin, which will show you how your business is doing in the profitability category.
3. How much are you making on products sold?
If you want to know how much you’re making on each sale, you need to take a look at your income statement and calculate your gross margin. Your gross margin shows at the amount of revenue you brought in before factoring in business expenses unrelated to your COGS.
Here’s how you calculate gross margin:
Gross Margin % = (Revenue – COGS) / Revenue
This number shows how much money your company is keeping as a gross profit after the cost of goods sold. If your gross margin is 15%, that means you’re only making $0.15 for every dollar of revenue you bring in.
If you want to get an idea of how much you make in dollars without the percentage, factor the gross profit without the margin:
Gross Profit = Revenue - COGS
When performing a small business audit, you can calculate gross margin to help you:
Assess your company’s efficiency
Predict the money you have from sales to cover additional overhead
Make pricing decisions
A decreasing gross margin is an indicator that your business may be on the decline, and means you might want to recoup some of your losses by cutting labor expenses or spending less on materials.
4. How much money is left over? For yourself? For investing back into the business?
Speaking of labor and materials, your gross profit is also a piece of the puzzle when it comes to figuring out how efficiently your business is using labor and supplies. Gross profit gives you a look at how much money your business is actually making for you.
In order to look at the overall profitability of your business, you’ll need to calculate the net income:
Net Income = Gross Profit – Operating Expenses
Your net income looks at the cash coming in and the cash going out. So while it doesn’t give an in-depth view of your business’s financial health, it does tell you one of the most important insights into business performance: Whether or not you’re making money.
5. What’s your debt situation like?
Unless you’re backed by a wealthy friend or family member, chances are you secured a small business loan like most people to help you grow your business.
You’ll want to look at your debt to total assets ratio when assessing your financial health to see just how much debt you’ve accumulated. You can calculate this with the following equation:
Debt to Total Assets Ratio = Value of Debt / Value of Assets
The lower the number you get from this equation, the better. For reference, investors often for business to have a debt ratio between 0.3 and 0.6. Companies that have a higher debt to total assets ratio are more likely to be riskier and financially unhealthy.
6. Are your products selling?
The higher your inventory turnover, the better. A low inventory turnover means you’re experiencing weaker sales volumes, or there’s simply not a demand for your products.
That’s why you need to assess how well you’re managing inventory by calculating your inventory turnover rate. This information is helpful when managing and replenishing your stock.
Step 1: Come up with your Average Inventory
Average Inventory = (Current Inventory + Previous Inventory) / 2
Step 2: Calculate Inventory Turnover
Inventory Turnover = COGS / Average Inventory
7. Do you have an emergency fund?
One easy way to think about financial health: will you still have money to pay the bills if something goes wrong? We recommend having three months of business expenses set aside to keep you nice and dry during the rainy season.
If shelling out money for an abnormal expense that arises puts you in a tough spot, you might want to take a deeper look at your company’s finances to see where you can cut back on expenses.
The best way to stay up on your company’s financial health is to keep track of your finances. Bookkeeping helps you better understand how your business is performing and can help you spot the red flags if things take a turn. If you need a little guidance in that department, check out this post on Bookkeeping Basics.