Knowing the details of your company’s profitability, costs, cash flow, and more is critical to staying on top of your finances, and growing your business. Here are five financial questions every small business owner should always be able to answer.
1. How much profit do you really make on your 10 largest customers? Why is this question so important? Because the profit you make on those big customers largely determines the profitability of your business. Consider how often they buy, how large their orders are, and how quickly they pay, as well as any special price concessions you give them in appreciation for their business. Your largest customer isn’t always your most profitable customer, so be aware and take action to increase profitability where you can.
2. What is the cost of each product you sell? Many companies figure their gross profit on a product by only deducting from the selling price the direct costs of manufacture or purchase. Unfortunately this is rarely the true cost of a product. You also have to consider the costs to receive, package, warehouse, and deliver it. Don’t forget the overhead cost of running your plant or warehouse, everything from electricity and extra insurance to the stock pickers’ wages, the janitorial service, and maintenance contracts on your equipment. If one of your products requires a disproportionate amount of overhead costs, an average overhead calculation for your company as a whole will never give you the right answer. Your most popular item could be a loss leader without you even knowing it.
3. How quickly does your inventory turn over during a year? Inventory that doesn’t move out of your warehouse quickly is often misplaced, broken, old, obsolete, or generally unusable. Or the market price drops and you have to mark it down to sell it. All of this takes money out of your pocket without giving you any benefit in return. The first step in preventing these situations from affecting your bottom line is to know how quickly your inventory turns and to note any changes in that rate. Then refine the overall turnover rate to an item-specific turnover rate, at least for high-cost items. Why? Because expensive items that don’t move may be hidden by fast-moving commodity items on your floor that have much lower margins.
4. How quickly does your business collect its receivables? What is the average day’s sales in your current accounts receivable balance (often called DSO)? Collections can get out of hand without you realizing it because you’re busy selling more and managing your company’s growth. Think of it this way: How much interest-free money are you willing to lend to your customers as a percentage of sales? Follow the trend of your DSO and take action when it starts moving in the wrong direction. If you’re getting strong margin gains in return for extending terms, that’s OK, but do this deliberately, not accidentally. As a follow-up, watch your accounts receivable aging trends as well, because old balances look the same as new balances in a DSO calculation, and it’s statistically proven that the older those balances, the less likely you’ll collect them.
5. If your business does what you expect it to, when will your cash reach its highest and lowest points of the year, and roughly how much cash will that be? Many chief executives track cash flow by following net income and the bank balance, neither of which is very useful in predicting future cash needs. Capital asset purchases; growth in inventory, receivables, and payables; debt service; and capacity expansion can all have a profound influence on future cash balances. The good news is that they all can be reasonably predictable with a little work.
Gene Siciliano is Your CFO for Rent and the president of Western Management Associates.