Your business’s livelihood depends on how hard you work, as well as how smart you work. This article will explain how you can use the same tools and techniques that the Fortune 500 companies use to make educated, informed business decisions to propel your business into success.

There is one place you can go to find out almost everything about your business including if someone may be stealing from your company, if you are properly controlling inventory, if you can improve cash flow, if you have enough working capital to support new financing, if you can afford to scale up/grow, and much more. That one place you go to find out all those things is your financial statements. Your financial statements have a plethora of information and should be used regularly to accomplish your business goals. The financial statements include (1) the income statement, also known as the profit and loss statement, (2) the balance sheet, and (3) the cash flow statement.

Step 1: Understand where to find the information you need.

  • The income statement shows your sales, cost of goods sold, all of your expenses such as rent, payroll, utilities, etc. This statement does not reflect actual cash in the bank and does not include any loan payments.
  • The cash flow statement shows your actual cash in and cash out. This will include actual payments deposited into your bank account and income received through the proceeds of a loan. It will also show cash that left your business for payments of expenses, loans, etc.
  • The balance sheet shows a one day snapshot of your assets on hand, that day, such as inventory, cash in the bank, real estate that you own, and accounts receivables. It also shows any liabilities or debts you owe. The difference between your assets and your liabilities equals your net worth. For example, if your assets are $50,000 and your liabilities are $35,000, then your net worth is the difference of the two, which is $15,000. It is possible to have a negative net worth as well. The balance sheet gets its name because your assets must balance, or equal, your liabilities plus your net worth.

Step 2: Analyze the numbers.

  • Cost of Goods Sold
    1. Divide your cost of goods sold by your sales to find the percentage for your cost of goods sold.
      1. Example: Cost of goods sold is $10,000 in January. Sales are $30,000 in January. So, $10,000 divided by $30,000 equals 0.33 or 33 percent.
  • Inventory
    1. Inventory includes raw materials, work in process, and finished goods.
    2. Divide your inventory number by your cost of goods sold, then multiply that number by the days in the cycle (such as 30 days for a month, 365 for a year, etc.).
      1. Example: Inventory is $44 at the end of the year as found on the balance sheet. Cost of goods sold for the year is $1,593 as found on your income statement. We’ll use 365 days for the year. So, $44 divided by $1,593 equals 0.0276. Now, multiply 0.0276 by 365 days equals 10 days. So, your “days inventory” is 10 days. This means that your business keeps inventory for about 10 days throughout the year before selling it. This is your inventory turnover rate.
      2. If your company is very seasonal in nature, then you should use the average inventory for the year in your calculation, or make your calculations based on a shorter cycle, such as one month increments.
  • Cash
    1. Accounts payable
      1. Divide your accounts payable by your costs of goods sold, then multiply that number by the days in the cycle (such as 30 days for a month, 365 for a year, etc.).
        1. Example: Your accounts payable is $134 as found on your balance sheet. Your cost of goods sold is $1,593 as found on your income statement. This is for the whole year so we will use 365 as the cycle. So, 134 divided by 1,593 equals 0.0841. Then we multiply 0.0841 by 365 equals 30.7, or 31 days. This is your “days payable,” which is the average number of days it takes you to pay your bills.
      2. Accounts receivable
        1. Divide your accounts receivable by your sales, then multiply that number by the days in the cycle (such as 30 days for a month, 365 for a year, etc.).
          1. Example: Your accounts receivable is $120 as found on your balance sheet. Your sales is $2,386 as found on your income statement. This is for the whole year so we’ll use 365 days as our cycle. So, you divide 120 by 2,386 equals 0.0502. Then, you multiply 0.0502 by 365 days equals 18.3 days. This is your “days receivable,” which is the average number of days it takes for you to receive payments from your customers.
        2. Working capital
          1. Subtract your current liabilities from your current assets.
            1. Example: Your current assets are $224 as found on your balance sheet. Your current liabilities are $200, also found on your balance sheet. So, 224 minus 200 = $24. This is the amount of working capital you have to use in your day to day operations after you’ve paid your obligations such as credit cards, loans, payroll tax, etc.

Step 3: Understand what the numbers tell you.

  • Cost of Goods Sold
    1. Once you’ve calculated the percentage for your cost of goods sold, you need to compare each month’s percentage. The cost of goods sold should remain stable. If it suddenly goes up one month, and your vendors are charging more, then it makes sense that your cost of goods went up. This may also indicate to you that it’s time to renegotiate your rates with your vendors. If, however, your vendors haven’t increased their prices and your cost of goods has increased, then you may need to look at customers and employees for possible theft or for waste within your processes (such as a bartender who tends to over-pour alcohol).
  • Inventory
    1. If your inventory turnover rate is higher than the industry norm, this can indicate that you’re keeping more inventory on hand than you need, which ties up your cash, and that you’re not forecasting your sales accurately. If the inventory turnover rate is lower than the industry norm, this could indicate a potential loss of sales due to the company’s inability to fulfill demand. Your inventory turnover rate is a quality and efficiency measure for your business.
  • Cash
    1. Accounts payable
      1. If your “days payable” is calculated to be more than the industry norm, this means you are slow paying, which could be an indicator that you don’t have enough cash on hand to pay in a timely fashion. However, if your “days payable” is considerably lower than the industry norm, this means that you are paying quickly. If you’re routinely receiving a discount for paying early, then that makes sense. If that isn’t the case, then it could mean that you’re using cash today that could be used for other operational uses. In other words, you can free up some of your cash flow if you choose not to pay too quickly, (but don’t pay late, of course).
    2. Accounts receivable
      1. If your “days receivable” is calculated to be more than the industry norm, this means that you’re not collecting the money that is owed to you in a timely fashion, which results in a reduction in your cash flow. If this is the case, you need to make a change in your collection procedures. If, however, your “days receivable” is less than the industry norm, it is good news because it means that you’re collecting your money quickly.
    3. Working capital
      1. Your working capital should be a positive number indicating that you have enough current assets (cash, accounts receivables, etc.) to pay what is currently owed. A positive number indicates the amount of capital you have left over to use for daily operations and growth. If, however, the working capital number is negative, that is a red flag. That indicates you may run into trouble paying your obligations. Over time, this could result in bankruptcy. Additionally, too high of a working capital number could mean that you have too much money tied up in inventory or that you’re collecting slowly on your accounts receivable. Ideally, you want a ratio over 1.2 but less than 2.0. That ratio is calculated by dividing current assets/current liabilities. In the example above, the ratio would be calculated like this: 224/200 = 1.12.

While there are many other calculations you could perform, the ones listed above are very good quality and efficiency indicators that you can use regularly to spot problems and make changes to your business’s operations in order to be more profitable and successful. Your local Missouri Small Business and Technology Development Center can give you industry norms, and help you analyze your financials, as well as understand how to use them to make better business decisions; all free of charge.

Rebecca Lobina
Management and Consulting Professional

The Missouri Small Business & Technology Development Center (SBTDC) offers free business counseling services to small business firms and individuals regarding issues such as management, marketing and financial analysis. Rebecca Lobina is a seasoned management and consulting professional with SBTDC who has multiple years of experience leading profit driven operations through business process improvement and goal attainment. Her proven record of effective short and long term strategic planning has improved operational processes, team effectiveness and profitability for her clients resulting in over 80 million dollars of economic impact.