It is remarkably difficult to start a small business. Only about half stay open for five years, and only a third make it to the 10-year mark. That’s why it’s vital to make every effort to succeed. And one of the most fundamental skills and tools for any small business owner is sound financial management.
What is Financial Management?
Financial management is the umbrella term for thorough bookkeeping, making accurate projections, creating financial statements and accessing business financing. Managing all of this efficiently lets you make the decisions to run your company successfully. Some of the first steps for good financial management include starting a budget, accessing lines of credit and opening a bank account for business expenses like payroll.
How Important Is Efficient Financial Management for Small Businesses?
In short, financial management is vital. A survey of successful business by the Federal Reserve Bank of Chicago found they had four things in common:
- Knowledge and experience with credit
- High level of unused credit balance
- Budget management and monitoring
- Cash set aside for payroll
Another survey found the more often a small business analyzes its budget, the higher its success rate. Those that do it annually, the U.S. Small Business Administration says, have a success rate as low as 25%. Done monthly or weekly, those rates climb to 75-85% and 95% respectively.
Why is Financial Management Important for a Small Business?
Financial management is important because it helps the business:
- See and understand its profit
- Make decisions on planning inventory and setting prices
- Determine whether it has sufficient cash flow to sustain operations and make decisions on buying assets
- Provide banks and investors with the financial reporting they need to loan money or invest in the business
- Conduct sound financial analysis for better business forecasting and projections
Common Small Financial Management Challenges
Managing your company’s finances is difficult and can be time consuming. Here’s a list of some of the common challenges you might face, and how and why it’s important to overcome them.
Managing a budget. Running a business is no easy task. On top of making payroll, paying for health benefits and navigating a complex tax code, there’s often economic uncertainty. Creating and monitoring your budget is the only way to remove some of the guesswork and help you prepare for unforeseen circumstances and make strategic decisions, like when to expand or hire new employees.
Making payroll with cash reserves. Consistently paying employees, payroll taxes, employee health benefits and the owners’ salaries from available cash is a strong indicator of financial health. Some 90% of businesses with excellent financial health in the Federal Reserve Bank of Chicago study said they always had enough cash from operations to meet these obligations. Only 50% of businesses that had poor financial health reported always meeting these obligations. If you’re not using cash reserves for payroll, set a goal to do so.
Staying on top of bills. With strong financial management comes the ability to meet your business obligations. This helps you avoid overage fees and boosts your credit. In fact, up to 35% of your credit score is based on history of on-time payment.
Controlling debt. No matter how strong your business, there’s a good chance that at some point you’ll need more cash than you have on hand. And whether it’s a small business loan or a business credit card, sometimes taking on debt makes financial sense. But taking on too much debt, maxing out credit cards or not meeting payment terms can damage your credit, increase the amount you pay in interest and drag your business down. Before taking on debt, it’s important to have a plan for how you’ll repay it.
Secure financing. Poor financial management leads to bad credit and the inability to receive financing from a bank. This can hamper growth by not taking advantage of business opportunities when they arise, like making capital expenditures for new equipment that could lead to increased revenue. Securing financing is challenging, time-consuming and requires expertise.
Understanding financing products. Good financial management helps small businesses prepare for economic uncertainty when securing credit lines and venture capital. An understanding of asset-based financing, accounts receivable financing, trade credit and equipment leasing was associated with higher financial health scores in the Federal Reserve Bank of Chicago study.
Three KPIs and Metrics for Financial Management
Creating accurate financial statements is the first step in building financial discipline. Each statement provides information that can be used to analyze profitability, efficiency and solvency.
1. Profitability. The income statement (or profit and loss (P&L) statement) helps a business see its overall profit or loss during a given time period. Use the data on this statement to calculate profit margins – including the gross profit margin, operating profit margin and the net profit margin. Here are the formulas to calculate those margins.
Gross Profit Margin:
Gross profit margin = total sales – COGS (or cost of sales) / total sales x 100
Higher gross profit margins indicate your company is efficiently using its assets to generate profits.
Operating Profit Margin:
Operating profit margin = operating income / revenue
Operating profit margin is also known as earnings before interest and taxes (EBIT). Increasing operating margins can indicate better management and cost controls within your company.
Net Profit Margin:
Net profit margin = net profit / sales x 100
Higher net profit margins indicate that your company is efficiently converting sales into profit. Profit margins will vary based on the industry. Comparing against peer companies will help you create benchmarks and goals.
2. Efficiency. Some metrics gauge how well your company is using its capital and assets to generate revenue. For these metrics, you’ll need information from your income statement and balance sheet, which is a snapshot at a given time of how much your company owes and how much it owns.
Return on Assets:
How efficiently does your business convert money invested in assets into profits? To benchmark, compare against others in your industry, as this will vary depending on what type of business you have.
Return on assets = net income / average value of assets x 100
Working Capital Ratio:
This ratio is a measure of liquidity and indicates your ability to pay short-term liabilities. A ratio of around 2 indicates good short-term liquidity.
Working capital ratio = current assets / current liabilities
Working Capital Turnover:
This measure is nuanced, and you’ll need to compare against peer companies in your same industry. It’s an indicator of how well you’re using capital to generate sales.
Working capital turnover = net annual sales / average amount of working capital for the same year
3. Solvency. To measure solvency, or your company’s ability to pay its long-term debts, use the cash flow statement, which measures how much cash enters and leaves your company. Calculating operating cash flow will indicate how well the company can cover its current liabilities.
Operating cash flow ratio =
net income + non-cash expenses + changes in working capital / current liabilities
If operating cash flow ratio is 2, for instance, it means your company earns $2 for every dollar of liabilities. Another way to look at it is your company can cover its liabilities twice over.
Seven Small Business Financial Management Tips
Here are seven steps you can take for better financial management:
1. Create a budget. Track your monthly expenses and compare them against historical expenses. When you see potential problems, such as overspending or a lack of capital, put plans in place to address them.
2. Put sound bookkeeping in place. The first step for bookkeeping according to the U.S. Small Business Administration is to get business accounting software. Whether just starting up, or trying to get a better hold of your finances, accounting software will save time and provide accurate and insightful data in an easy-to-understand format.
Make sure to open a separate business checking account. Reconcile accounts at least every month. Track all sales by register tape, invoices or a sales book (or software) and deposit all sales and link deposits with sales documents. Don’t spend cash sales. Write checks for all business expenses or use a business debit card.
3. Create a cash flow projection. Make sure cash inflows from accounts receivable will cover cash outflows. This helps the business set goals and change course when needed to meet them. This is particularly important for seasonal businesses, where a few months of the year may account for the majority of the company’s sales, and startups just getting off the ground.
4. Get a business credit card. Charging expenses to a business credit card makes it easy to track and monitor spending. Many business credit cards have other perks like no-interest financing for 60 days and cash-back rewards.
5. Build financial knowledge and personal financial strength. Start developing a profit plan when seeking a loan. It should include a statement of purpose, a list of the business owners, a description of the business and how it makes money, financial statements and insurance documentation. Also, improve your personal credit score. Many small business owners use their own score to secure financing.
6. Acquire financial management software. Key formulas and reports are built into these solutions, which can save time and lower the likelihood of errors by automating processes for invoices, financial reports, data collection, document storage and compliance.
7. Get help. If possible, employ a small team to handle things like accounts payable, accounts receivable, payroll, reporting and financial statements, putting financial controls in place and providing guidance on tax and compliance matters. A survey from Robert Half, a human resources consulting firm, found that businesses with under $25 million in annual revenue employed a median of three people in finance functions.
How Financial and Accounting Software can Help Solve Financial Problems
Keeping a budget and monitoring your finances is vital for your business to succeed. And key formulas and reports can help you track the financial health of your business and obtain funding from lenders and investors.
But tracking all the invoicing, financial reports, data collection, document storage and compliance is time consuming and prone to error when done manually. Business accounting software can help reduce costs and automate these tasks. It also generates predictive reporting and financial modeling. Business accounting software puts accurate financial data into dashboards and charts so you and your team can access up-to-date financial information. This gives you the confidence to make better informed decisions and more easily set goals and track progress toward goals.
Sound financial management is the engine that drives your businesses. Without it, your business will not get off the ground or get you where you want to go. It starts with creating a budget and acquiring business accounting software. From there, you’ll have the information you need to help you make the decisions that can help drive your company forward. Learn more about financial management solutions.