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How to Use Financial Tools To Grow Your Business
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The How-To Business Book
11/20/2000
By: Lori Green
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Even if you're successfully running your business with an intuitive, spontaneous management style (a/k/a, “seat-of-the-pants”), taking command of your company's key financial indicators is critical to its future sustainability and growth.
To achieve long-term gains, financial experts advise keeping a sharp eye not only on the bottom line but on the financial ratios - how your various results interrelate. Understanding your business' fundamental ratios enables you to measure and plan more accurately and effectively. For example, certain ratios can tell you if you've got a shot at increasing profits next quarter, or widening margins next season.
And honing your financial management skills will favorably impress bankers looking over your next credit application.
To get a snapshot of your company's financial situation, don't wait until tax time to call your accountant. Ask for a monthly, quarterly or annual “compilation report” for your company. This consists of at least a prepared income statement and balance sheet. For a more detailed picture and a more powerful tool, request a “review quality” financial statement, which includes income and balance sheets, a statement of cash-flow, and comments or notes on the financial condition of your business.
Because lenders or business appraisers will zero in on a company's cash flow-to-debt ratio, your accountant should assist you in determining the consolidated debt-coverage ratio. A healthy business will have a ratio of 1.2-1.5. That means that your cash flow at a given point in time is sufficient to cover total outstanding debt, with a bit of cash cushion. Banks, for example, like to see a cushion of averaging about 25 percent.
If your cash flow to debt ratio is below 1, you need to know why and to develop a creative and sound approach to elevating that number. An attentive prospective lender can to help guide you, but it's better if you build up an adequate cash flow number before seeking financing.
Typically, if your earnings are strong, your cash flow position should be adequate.
However, servicing large debt on a short-term basis can overshadow good earnings and make them looking weaker than they actually are. For instance, if you are buying equipment on a two-year term, as opposed to a more typical three to five years, your cash-debt ratio is going to be higher, making debt service coverage look a little weaker. But as long as you can explain that you prefer to pay off debt a little quicker, it is likely not to adversely effect a financing decision or valuation.
If a company's cash flow-to-debt ratio isn't meeting the bankers' preferred 1.25 level, the astute banker is likely to go back to see why the numbers are low. For instance, I could be that gross profit is out of line, and the business owner may want to begin to think about increasing prices. Or it could be that expenses are out of line and you're paying too much for insurance or advertising.
Most banks making commercial loans can give help you see how your key ratios compare with other businesses in your industry with roughly the same asset size.
In addition to cash-to-debt, other important financial indicators affecting both cash flow and net income include the number of days to collection of your receivables and days in inventory. Are invoices being paid within a reasonable amount of time? If not, cash flow is going to suffer. And slow turnover of inventory often raises warehousing costs, and increases the risk that goods won't move off your shelves at all.
Maintaining a current financial profile that you can explain to financial professionals will help you establish a bankable track record. So when you need working capital for more trucks or personnel, a lender can readily see your revenue and cash-flow position and can approve credit requests more quickly.
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