The 4 Essential Financial Numbers for a Small Business
Knowing what to pay attention to and then paying attention to those things.
For me, financial statements are one of the more successful examples of making things as simple as possible, but not simpler. Accountants can summarize the activity and performance of every kind and size of business — from a corner café to a trillion dollar semiconductor manufacturer — in three standard reports: the income statement, the balance sheet, and the cash flow statement. For centuries, these statements have proved to be indispensable tools in the business world, helping people both inside and outside a company assess its health and prospects.
But they come with an important caveat, one that disproportionately affects the small business segment. Financial statements are meant for “users who have a reasonable knowledge of business and economic activities and who review and analyze the information with diligence.”That is, they’re only as simple as possible for those already comfortable with reading and interpreting them. And even this group has to put in the work. For the rest of us, unfortunately, things can’t be made any simpler.
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Because entrepreneurs and small business owners are unlikely to have a finance or accounting background, they rarely fall into the “already comfortable” group when it comes to reading financials. They struggle to “review and analyze” the rows of accounts and numbers in their income statements and balance sheets, never mind the cash flow, and never mind “with diligence.”
There’s a disconnect between what small business owners do in their business, the real work, and how the result of those efforts are portrayed in their financials. That portrait isn’t simple. It’s a Jackson Pollock. Kris, one of our Origami CPAs, has told me several times that a common request he’ll get from clients when discussing their financials is, “Can you just tell me how I’m doing?”
A small business scorecard
What are the essential numbers, then, in small business financial statements? For a business with sales under $5M (i.e., the typical small business), what are the numbers that tell the owners and investors how it’s doing?
Having looked through the financials of many such businesses over many years of their existence, a few that have grown past the $5M mark, many that have closed shop, and many more that have stayed in the range with varying degrees of success, I think it comes down to paying attention to four key numbers: sales and net margin from the income statement, operating cash flow from the cash flow statement, and cash and cash equivalents from the balance sheet. For me, these four numbers are the vitals, the best indicators of a company’s financial health and future prospects.
Executives and managers in larger businesses rely on scorecards or dashboards to monitor the overall state of their companies. Because these firms involve complex moving parts, their scorecards can get quite detailed, showing trends and performance vs. targets for many financial and non-financial metrics. Decision-makers want to see not just the financial results (sales, profits) but the operating metrics (customers, service times, service quality, productivity) driving those results. They’re not thinking about survival; they’re looking for wins.
Small businesses have to keep it simple. They have fewer moving parts and fewer resources. Survival isn’t assured. Scarce resources need care and full attention. Attention has an outsized influence on life outcomes. You are (or you become) what you pay attention to. Small business owners can easily become distracted or pay attention to the wrong things. They should stick to the four basics.
Every small business owner pays attention to sales. It’s the top line of the income statement, the reading that’s easy to understand, the one that drives all the others.
Sales grow as your business finds more customers for its products and services or sells more products and services to the customers it already has. Sales can also grow if you raise your prices. Assuming you don’t chase too many customers away.
In the startup stage, small businesses have to grow sales to the point where they at least stop losing money. It’s a struggle to exist. You’re just hoping you’re offering something that enough customers will want at the price you’re offering it for. Before the money, patience, and nerve run out.
Further along, you’re still looking for growth but you’re probably going to be focused on profitable growth. How can I move from selling things to making money selling things? As a business and as a working business owner.
While sales growth is a sort of vindication, sales decline is an accusation. Something is broken or no longer working. You need to find that part and fix it. Zero sales growth can work for a well-functioning, profitable business, at least for a time. But, without forward momentum, these states have a tendency to decay.
Each business generates sales using a different cost structure. Each small business owner has to carefully manage that cost structure to generate net margin, the bottom line of the income statement. No margin, no profit. No profit, no point.
For most small businesses, the biggest expense categories are the cost of goods sold, wages, and rent. Each takes its chunk as sales works its way to the bottom line. But the biggest chunk, the one that’s hardest to wrangle is usually wages.
This is because small business owners are often quick to hire and slow to fire. They delegate too soon. They hire for a sales level that’s still a ways off. And when faced with the inevitable pressure of supporting the higher cost structure from a lower than forecast sales level, they’re slow to react. There’s a certain obligation most small business owners feel toward employees.
But someone has to pay the price for losses and marginal profits. And that someone is the business owner. She pays the price through injecting more capital into her struggling business or by accepting lower returns on her investment. She can do that, of course. It’s her business. But it’s not a healthy business. One that anyone else would ever want to own.
Operating cash flow
Because of how accrual accounting works, the net income (profit) for a period often doesn’t equal the cash generated for the same period. For example, depreciation and amortization is a non-cash expense that lowers net income on the income statement but doesn’t actually affect cash flow. Net profit can overstate or understate the cash flow generated by a company’s operations in a given period. Small business owners have to constantly manage cash flow to pay bills and expenses as they come due. This is why you have to understand and watch operating cash flow, not just profitability.
There are three main factors, other than depreciation, that cause operating cash flow to be different from net income. Each of these factors can quietly eat/tie up cash and lead to a cash crunch. You have to be paying attention.
Your operating cash flow will decrease if your accounts receivable (AR) increase, all other things being equal. AR is a service you provide to your customers. Usually, as sales increase, AR increases; a percentage of customers will pay on credit. If sales increase rapidly, more and more of your company’s assets will be tied up in AR. And, simply due to the nature of AR (some customers will take longer to pay, some will end up written off as bad debts), your company will risk running out of the cash it needs to pay for the growing bills and expenses required to support the higher level of sales.
Your operating cash flow will decrease if your inventory increases, all other things being equal. Inventory, especially for retailers who lack the discipline and systems to efficiently manage it, has a tendency to soak up company profits and cash. Instead of being available to fund expansion or to distribute to shareholders, the money from profits ends up sitting on shelves in stores and warehouses, incurring additional storage expense. Inventory’s value is also more precarious. It carries the risk of going stale or out of date, leading to markdowns.
Your operating cash flow will decrease if your accounts payable (AP) decrease, all other things being equal. AP is the credit that your suppliers extend to you. This can be a valuable source of funds to run your business. If you make it a habit to pay your suppliers quickly but collect from your customers slowly, you are going to feel some pain in your cash flow. You’ll also feel that pain if you pay your suppliers early to take advantage of discounts.
Operating cash flow is a good benchmark to measure the success for your company’s normal operations. It’s a check to make sure the company is efficiently converting its profits to cash. Weak or negative operating cash flow is a danger sign and needs prompt attention.
Cash & cash equivalents
The first rule of business is to not run out of cash. As a small business owner, you should always know how close you are to catastrophe. The cash and cash equivalents line on the balance sheet tells you what your company owns in terms of cash. If you have credit lines or company credit cards, you may have access to more cash than that, but that’s usually a step further on the tightrope. Managing cash flow is usually the most important financial activity for a small business that stays under $5M in sales.
The other reason you want to pay attention to your cash balance is that you’d like to see it grow. If this is happening, one useful piece of advice for any small business owner is to build up a cash reserve in the business, two or three months of expenses. Cash in the bank helps you sleep better. Setbacks don’t lead to meltdowns. You can absorb life’s bumps and bruises, a pandemic even.
If your business is doing well enough to grow its cash balance, you’re lucky. In the early days of this success, resist the temptation to spend it or take it all out for yourself through dividends. Build the cushion first, and then decide what to do with the excess: use it for growth or pay it out as dividends.
First say to yourself what you would be; and then do what you have to do.
These four financial numbers are the vitals for a small business. If you own a small business, you should know what they are each month. You should know their short and long-term trends. And you should set goals for each: a specific objective and a deadline for achieving it.
Achieving the goal will require commitment, persistence, and a plan. How will you move from the present state to the goal state? The plan could break down the overall goal into a series of sub-goals, each building to the next. What steps will you have to take to get your key numbers higher?
Each sub-goal is a measurable financial result (monthly sales up by 5%, cash in the bank up by $60K, etc.) that you plan to achieve in a set amount of time (in three months, by the end of the year). The plan focuses your attention. The alternative is to get caught up in day-to-day issues, have time pass, and end up not much further than where you started. By goal setting, you’re making things happen rather than waiting for things to happen to you.
There are other benefits. To hit your financial goals, you have to become a better player in finance, management, and business. More diligent, more attentive. You’ll have to make changes to the way you do business, your processes, your cost structure, the way you allocate resources. You’ll try things to get new customers. You’ll try things to motivate employees. You’ll develop new products, new markets.
These experiments will test your theories on how your business and industry work, how your customers think and feel, what they really want. Your financial numbers will show you the results of your experiments. You’ll update your theories as you discover winning moves. Your theories will become more accurate, more useful. As your theories and confidence improve, you’ll make more winning moves.
According to the Educational Attainment brief (pdf) from the Kaufmann Foundation, a little over half of entrepreneurs in the United States (51.4%) had at least a bachelor’s degree. And according to Coursera, business, at 19%, is the most common major for undergraduate degrees. If we (generously) assume all business majors are comfortable with finance and accounting, that works out to around 1 in 10 entrepreneurs having an educational background that makes them comfortable with financial statements and analysis. Of course, many small business owners without such a background develop financial understanding and skills along the way. But, in my experience, few work to the level of comfortable and diligent.
It even turns out that the miracles of modern AI are a result of computer scientists discovering ways to teach machines to pay attention to the right things: Attention is All You Need (pdf)