It doesn’t matter how brilliant your business ideas are, how well you connect with customers, or how experienced you are in your field. To start and grow a lasting, profitable operation, you need a strong understanding of finances.
April is National Financial Literacy Month, so it’s the perfect time to improve your financial knowledge and skills. Whether you’re looking to brush up on budgeting basics or collect new strategies for maximizing profits, we’ve got you covered.
Here are six skills to cultivate—whether you’re an aspiring entrepreneur writing your first business plan or an experienced business owner managing multiple operations.
1. Understanding and analyzing financial statements
Knowing how to read and analyze your business’s financial statements gives you a deeper understanding of your operation’s overall financial health, and helps you make more informed decisions about what to improve upon.
Here are the three statements you should be familiar with:
- Balance sheet: Your balance sheet lists your business’s assets (what you have), liabilities (what you owe), and equity. It shows your overall debt ratio, and gives you a clear idea of how easily you can cover short-term operating needs and repay future debts.
- Profit and loss statement: Also called an income statement, your profit and loss statement shows your business’s revenue, expenses, and net income over a specific period of time (like a month, quarter, or year). It’s a broad overview of how profitable your business actually is, so you can use it as a starting point to figure out how to boost revenue and profits.
- Cash flow statement: Your cash flow statement gives you a line-by-line breakdown of all the money that enters and leaves your business during a specific period of time. It shows you how much money you have at any given time to pay bills and loans, maintain operational expenses, process payroll, and invest in growth activities. You can use cash flow statements to figure out where to cut expenses and how to balance accounts receivable and payable for steadier cash flow.
Budgeting is an essential skill for small business owners managing multiple streams of spending. Without a realistic, clear-cut budget, you risk spending money you don’t have or not spending enough to stand out in your market. Smart budgeting makes it easier to maximize your ROI, cut expenses, plan for seasonal changes and economic fluctuations, and build an emergency fund.
Regardless of whether or not you already have a budgeting process in place, these tips can help you build a more effective budget.
Review industry standards
Research average budget sizes for your industry and business model, so you know how much money your competitors are putting toward expenses and production costs. You can search recent online reports, talk to other small business owners in your community, join a professional industry organization, or consult a business accountant who specializes in your field.
Track and regularly review your expenses
When you record and review your expenses on a regular basis, you’ll start to see patterns—and notice places where you can either cut back or double down. Your fixed expenses are the costs that stay the same from month to month, such as rent or mortgage payments, loan payments, payroll, internet bills, and insurance premiums. Variable expenses are the costs that fluctuate from month to month. Think: advertising and marketing costs, production costs, supplies and materials, utilities, and consultant fees.
Rank your expenses by necessity and ROI
Assigning a numerical value to your various expenses gives you a better idea of which ones are critical to business operations, and which ones you can sacrifice if you’re in a cash crunch. With this strategy, you won’t have to review your expenses line by line when you’re trying to cut costs—you can group expenses by their value then reevaluate them.
Put a “1” next to items that are non-negotiable and essential to your business’s day-to-day functioning (like rent for your storefront or your point-of-sale system), a “2” next to items that are important but have a little room to change month to month (like inventory or packaging materials), a “3” next to items that create value but can be tightened up (like marketing expenses), and a “4” next to items you enjoy but bring the least value to your bottom line (like subscriptions or office decor).
Put a certain amount per month in an emergency fund
Make sure you’re setting aside a set portion of your business’s monthly budget to go to emergency savings. After all, you never know what can happen—economic downturns can slash your revenue in half, while local natural disasters could force your business to shut down temporarily. It’s a good idea to have at least three to six months of operating expenses in an emergency fund at all times.
Balance long-term goals with immediate needs
The most successful budgets address your business’s immediate needs, while also leaving room to work toward long-term goals and invest in growth activities. Carve out time at the end of each quarter to review your budget and compare it to your income and cash flow statements.
This will give you a better sense of what you were able to achieve with your budget. From there, you can make more informed decisions about how to rein in your budget or how to expand it to make room for investments with high ROI potential.
3. Improving your business credit
Having excellent business credit gives you more financial freedom and opportunities. That’s because everyone from business lenders and credit card companies to landlords and vendors review your credit when deciding whether or not to work with you.
With a higher credit score, you have a greater chance of being approved for financing and getting more favorable terms, like lower interest rates and higher borrowing amounts. There are a handful of ways you can improve your credit score:
- Update your credit information.
- Pay bills on time.
- Take out a new credit card or business line of credit and make payments on time.
- Maintain a low credit utilization ratio on your credit cards and lines of credit.
For more information on how your business credit score is determined and what you can do to influence it, check out these five steps to raising your credit score.
4. Managing your debt load
Opening and growing a business requires capital—some of which you may need to borrow. A key part of overseeing your company’s finances is figuring out how to manage your debt load so you get the most out of your investment and when it’s advantageous to take on new debt.
Managing your debts comes down to organization and planning. In addition to automating your monthly repayments and closely tracking your credit utilization, it’s also smart to look ahead at your loan repayment schedule and cash flow forecast to see if you can increase your monthly payments to accrue less interest and pay off your loan sooner.
Determining when to take on new debt or refinance current debt requires crunching some numbers. You can start by calculating your business’s debt-to-income ratio (DTI), which gives you a better idea of how much debt you have relative to how much income is coming in.
Many lenders look at your DTI when deciding whether or not to give you a business loan. You can calculate it using this formula: (Monthly debt repayments / Monthly gross profits) x 100 = DTI%
For example, if you have $4,000 of monthly debt repayments and $15,000 in gross profits per month, your DTI would be 26.6%, which means nearly 27% of your monthly gross profits are going toward repaying your debts. Your DTI should be at least below 50% to qualify for a loan, but many business lenders like to see DTIs at 36% or below.
Another tool you can use to determine how much debt your business can afford is debt service coverage ratio (DSCR). Calculate your DSCR in just a couple steps with our free calculator.
From there, it’s crucial to evaluate your business goals, recent financial statements, and resources. Check out these six factors to consider before getting a business loan, or discover seven reasons to get a business loan when your operation is thriving.
Want to estimate your business’s monthly payment for a potential business loan? Use our calculator here.
5. Assessing profit potential
Learning how to assess the profit potential of a particular product, service, or investment is key to making decisions that set you up for financial success. In addition to conducting market research, there are few helpful financial metrics you can use to gain some insights.
Cost of goods sold (COGS)
You can estimate your projected bottom line by subtracting COGS and other expenses from your revenue. Use this formula to calculate COGS: Starting inventory costs + additional inventory costs – ending inventory = COGS
As an example, let’s say your business’s inventory costs at the start of the year add up to $100,000. You make $400,000 worth of additional inventory purchases throughout the year and finish with $75,000 worth of inventory at the end of the year. Following the formula, your COGS would be $425,000.
Cash flow forecast
A cash flow forecast can help you budget more easily and figure out which changes to make to increase your revenue. You can make a forecast by reviewing your past cash flow statements and income statements. Choose a period of time you want to forecast for, like the next quarter, then estimate your incoming sales, incoming cash, and outgoing cash. Your cash flow will equal your cash revenue minus your cash disbursements.
A break-even analysis tells you the point at which your revenue completely covers your expenses. You can use a break-even analysis to gauge whether or not you’re pricing products correctly, or use it to assess the money and effort that would go into developing a new product.
The formula for the break-even point is: Fixed expenses / (Price per unit x variable cost per unit) = Break-even point.
Imagine, for example, that your pottery business has $20,000 of fixed costs per month, including rent, taxes, and payroll. It costs $15 in raw materials, packaging, and shipping to make each piece of pottery, and each item sells for roughly $25. Using the formula, that means you would have to make and sell 53 pieces of pottery each month to break even. However, you’d have to make and sell much more than that to make a profit and account for your variable expenses.
6. Investing wisely
Investing is more of an art than a science, but savvy business owners know how to make strategic investments. This can take many forms, like investing in tools—a new delivery vehicle, for example, or inventory management software—to streamline your business.
It might also mean investing in people, like a new marketing manager, or in research and development (R&D) activities, like making prototypes or testing new quality assurance processes. It can also include more traditional investing, like putting money in stocks or small businesses you want equity in.
Here are some questions to consider when debating a potential investment:
- What does the investment call for monetarily? Do I have the cash right now to invest or would I need to obtain financing?
- What does the investment require in terms of my time and resources?
- What are the potential benefits of making the investment (e.g. more customers, greater monthly sales, more time back for your employees, etc.)? Can you quantify this ROI?
- How likely are you to see an ROI from your investment—and when?
How to improve your financial knowledge as a business owner
You don’t need to have a masters degree in business or finance to be a smart financial steward of your business. You can improve your financial knowledge with experience, intention, and persistence. Here are a few ways:
- Take a course: Deepen your knowledge by enrolling in a university or community college course on cash flow management, business financing, or forecasting.
- Hire a CFO: If you want to learn from someone more experienced, consider hiring a full-time or consultant-based CFO who can oversee your operation’s finances and advise you on growth strategies.
- Take advantage of your business accountant: If you have a business accountant, use them as a resource to ask questions and break down complicated tax information.
How to support your employees’ financial literacy
Part of being a good business owner is making sure your employees are financially literate, too. You can empower your employees to make the right financial decisions for themselves by:
- Clarifying your compensation policy: Consider creating a handbook for employees that explains how they can earn tips, bonuses, or wage raises in your business. You may also want to hold an annual workplace meeting or one-on-ones to answer compensation questions. Keep in mind that part of having a clear compensation policy is abiding by your state’s laws around compensation transparency, whether that includes writing the wage range in your job description posts or giving employees a salary range for their role if they ask.
- Hiring a financial expert to talk with your employees and answer questions: Consider bringing an accountant or financial planner to your workplace to give employees advice on personal budgeting, planning for retirement, building a savings, preparing for tax time, and what to claim on their W-4s for tax withholdings. You can also work with a financial expert to create a 101 guide you can distribute to employees as well.
Invest in your financial health
Improving your financial skills has a direct effect on your business’s profitability and longevity. If you need extra capital to invest in a growth project or gain more stability, consider Funding Circle. Our business term loans and business lines of credit have easy applications and fast, flexible funding. Apply today in just a few minutes.