“Your spending is out of control,” my accountant said as she looked at me across the conference room table.
I was confused, and for a moment I thought I hadn’t heard right.
“What are you talking about?” I said. “Our bank balance is fine. And we’re making nearly 3 times as many sales as we were last year.”
“Yes, your sales are up compared to last year. But your income went down by [a very large number].”
I was shocked to hear that. My partner and I were rather pleased with ourselves when we walked into our company’s Annual General Meeting. Ready to be congratulated for the big increase in sales, and to brag about how much we planned to accomplish in the coming year.
I didn’t expect that kind of meeting. But I have to admit I wasn’t completely surprised…
You see, we didn’t have a clue about our numbers.
Here’s the thing. About 5 years ago we started a business to sell information products online. And in the beginning it was easy. We had a great idea, we were experts in our field, and we applied our creativity to produce one unique product after another.
After years of grinding it out in the 9 to 5, we couldn’t believe how easily the profits rolled in. Even when we eventually hired our first virtual assistant, our overhead was very low. We were experts in our subject matter, but neither of us had a business background. But that didn’t seem to matter — much to my surprise.
Sure, we’d heard about “tracking” and “metrics”, and we made a few attempts to set systems in place because we knew it increased sales. But apart from that, we really had no idea what we were spending on or where we needed to invest. That’s what accountant’s are for, right?
And we weren’t alone in that. The vast majority of small business owner’s don’t receive regular financial reports from their accountants. And according to Chuck Kremer and Ron Rizzuto, authors of Managing by the Numbers, 90% don’t know how to interpret that information or use it.
Well guess what?
That attitude will catch up to you.
Your business will grow beyond the stage where just keeping an eye on your bank balance isn’t enough anymore. You’ll take on more employees and overhead. You’ll invest in projects with a slower return. And your “machine” will be much more complicated.
Your job as the business owner is to steer this ship. Guessing and instinct won’t work anymore.
The good news is you don’t have to be an accountant to master this stuff. My background is Anthropology, and I write travel stories in my free time. I work with words and I count on my fingers for anything higher than 10.
But one of my strengths is that I’m never ashamed to admit I don’t know something. Willful ignorance is shameful. Asking questions never is. Don’t be afraid to start small.
Before we began our Board of Directors meeting for the year, I turned to our accountants and said, “Could I have a couple hours with you two after we’re done?” I reached into my briefcase with a sheepish look and pulled out a book called Financial Management 101. “I have a few questions…”
They giggled of course — most of our meetings involve a certain amount of giggling — but they were happy to help. And it was worth every penny.
Understanding your business numbers is about much more than just knowing where your money is coming from, or making penny-pinching budgets. You’ll be able to quickly gauge the health of your company over a given period of time. And you will also be aware of your spending patterns, and of cycles in your sales — periods of higher sales and dry periods when you should expect a dip in revenue.
At minimum, the three key reports you need to understand are your Balance Sheet, Income Statement and Cash Flow Statement. Keep a close eye on these three numbers in particular:
- Net Profit is captured on your Income Statement. It tells you whether or not you’re making money — in other words, whether your sales exceed your costs over a given time span. But be aware that this number can also be distorted by variations in cash flow, so you’ll also need to track OCF.
- Operating Cash Flow (OCF) is captured on your Cash Flow Statement. If your OCF is consistently positive, you know you’re generating enough cash from operations to meet your regular expenses. If your OCF is consistently larger than Net Profit, it also indicates that you’re doing a good job of turning your profits into cash. If you don’t have a healthy OCF, you’re on the way down — even if you’re showing profits.
- Return on Assets (ROA) is calculated by taking the Net Profit from your Income Statement and dividing it by the average Assets from your Balance Sheet. (To get your average assets for a given time period, add together the assets from the start of the period you’re tracking and the assets at the end of the period and divide by 2.) ROA tells how well you’re doing at managing sales and expenses, and how effectively you’re managing your assets.
If you want to make these statements work for you, you need to track them over time so you know whether your performance on these three “bottom lines” is improving or declining.
I’ve requested a Balance Sheet and Income statement to be prepared for me every 6 months, and a Cash Flow Statement every month.
When you learn how to read your financials, I bet you’ll also discover some things that seem totally counterintuitive to you.
For example, we always thought that to make more money we should just create new products to sell. That makes sense, right?
I thought so too. But it turns out that three to four months goes by from the time we first start investing in production to the time we make our very first sale. That’s called your Operating Cycle, and it doesn’t just matter for manufacturers or brick and mortar retailers. It turns out that we were carrying the costs of new product development for several months. Our cash flow had to sustain that. The Return on Investment for new products is also much more gradual than I previously believed, so it took us much longer than we realized to make a profit on them.
If you don’t understand these cycles in your own business, you can suddenly find yourself pinched for cash — and pinched for sleep too when those 3am worries set in.
Tens of thousands of businesses go under every year while still turning a profit, because they didn’t know how to track their Cash Flow.
Understanding your numbers will keep you out of these traps. And it’ll help you get the most from your accountants too. You’ll know exactly what information to ask for, and exactly which reports you need in order to increase your profits quickly and systematically. You won’t be flying blind anymore, because you’ll know precisely where those funds should be invested to fuel growth.
If you’re just starting out — or if you’ve been at it for a few years like we have — go online and pick up a stack of books. The two that I mentioned in this article are a great place to start. Block out some time and study this stuff. And then sit down with your accountants and ask questions, even if you think it sounds dumb. That’s your job as a business owner. And it’s all part of transitioning from that “start up dream” to a mature business.
I promise you it’s not difficult. It’s like learning a new language, or cracking a code. You’ll be amazed at the patterns you start seeing in your figures. And despite vivid flashbacks of getting kicked out of high school math class, you might even find you enjoy it, like I did. You certainly will appreciate your efforts at your next company meeting, and every time you look at your bank account.[Ed. Note: Ryan Murdock is the author of Personal Freedom: A Guide to Creating the Life of Your Dreams. When not helping people find their own brand of personal freedom, Ryan travels the world’s marginal places as Editor-at-Large (Europe) for Outpost magazine. He recently released his first travel book, called Vagabond Dreams: Road Wisdom from Central America.]