How to Keep Your Financials in Good Health
Just like an annual physical at the doctor, a periodic overview of your financial statements can be a window into the health of your business. Whether you perform the analysis yourself or enlist the help of a professional accountant or other specialist, here are some key items to consider.
Review Multiyear Spreads
Your banker should be able to share with you something called “spreads.” This is a multipage report that compares your detailed financials from year to year. If you do not have access to spreads, you can put together a similar report with a simple spreadsheet that shows each line item of your financials laid out for multiple years.
Spreads are valuable because they reveal financial trends by “common sizing” each line item of your income statement and balance sheet. For example, you may see that revenues have increased by 10 percent each year for the last five years, but net income as a percentage of sales has not changed. This could reveal that your margins have shrunk or that your expenses have increased.
Dig Into the Details
The more detail, the better, so it’s best if you can break sales into multiple categories such as sales by product or service. You may find that while the business is making money overall, one particular product may actually be losing money. If that product is not essential to your business, it may be prudent to discontinue it.
Conversely, if one particular product has higher margins than the others, you could shift your marketing focus to increase sales in the higher-margin product line.
You also will want to include as much detail as possible on your expense categories and calculate each expense as a percentage of revenues. By monitoring the trends in expenses, you can zero in on the ones you need to manage.
An obvious example is fuel costs for companies that have transportation expense. As fuel costs rise, your cost of goods will rise, too, and you should pass that increase on to your clients if possible. However, there are less obvious costs that can sometimes creep up.
Manage Cash Flow
Cash flow is the pulse of your business, and it can make or break you. A simple cash flow calculation is EBITDA, which is your Earnings (net income) Before Interest, Taxes, Depreciation and Amortization. Your EBITDA should comfortably cover your monthly debt payments and allow a cushion of 20 percent. This is the same concept as a Debt Service Coverage Ratio (DSCR), which many banks include as a loan covenant. If your bank requires a DSCR of 1.20, they want your EBITDA to be 120 percent or more of your loan payments.
Insufficient EBITDA is a red flag that should be immediately addressed. There are many businesses that seem to be successful and profitable at first glance, but do not have adequate cash flow to cover their debt obligations.
Once you begin reviewing these key vital signs regularly, you can quickly assess the health of your business.