In a nutshell: It might be tempting to focus only on the money coming into your small business, but don’t ignore the amount of money that’s going out. Learn how to track your expenses and figure out if you need to make difficult decisions.
Most business leaders focus on increasing income and going after new customers, intent on raising the amount of cash flowing into the company coffers every month.
That’s understandable. But it’s only half the equation. The other half involves cash flow and expenses. It’s an area that can prove difficult to contain. It may also lead to a business – especially a small one – getting into deep financial trouble.
Companies without a detailed picture of expenses may run low on cash, making it hard to plan for expansion and growth. Even worse, it can prove difficult to buy needed equipment, supplies or even make payroll.
Clearly, getting a strong handle on costs can make the difference between business success and failure.
First, get a clear, detailed picture of where finances stand at the current moment. Here are some areas to keep in mind, Mike Periu wrote in a post for American Express’ OPEN Forum.
- Revenue: How much is revenue growing during this period compared to the previous one? How much revenue is coming from one client? (The goal is to have no one client account for more than 10% of total revenue.) How much money are you making per employee? The higher the ratio on the last one, the better.
- Profits: Here you want to look at gross profits, which is total revenue minus the cost of the goods sold. You also want to check operating profit margin, which is revenue minus both costs of goods sold and operating expenses, divided by revenue. The higher the margin, the better.
- Operational Efficiency: How quickly do you collect on accounts receivable (money your customers owe you)? And how well do you manage your inventory? Higher numbers in both areas indicate you know how to use your resources.
- Liquidity: Can your business use its existing cash and other assets to pay off short-term obligations? Divide your current assets by current liabilities to find out.
Cash Flow and Expenses
Another crucial step is to create a cash flow statement. It should include net cash flow from business operations, investments and financing activities (such as bank loans). The combination of the three creates your total net cash flow.
The cash flow statement will help determine if the cash coming in is growing and whether net cash flow is positive. It also gives you a handle on exactly how much money you are bringing in.
The you should examine your expenses. Take a detailed look at every cost and determine its percentage of total revenue. That’s a quick way to identify where you may be spending too much.
Compare the expenses to last month and a year ago on the same date. Also, look at the rolling average – the average spent within a particular time frame.
Look out for items that are costing more than the original budget called for at the beginning of the year. Consider the rationale behind every single expense. This helps establish whether the expense added value to the business.
Many businesses find that it is cheaper to outsource some tasks rather than trying to do them in-house with full-time employees. Doing everything in-house provides more control over every aspect of an operation. But in some areas – technology services such as data storage and maintenance are common examples – it can be advantageous to hire a third-party vendor.
This also can prove useful for back-office functions. As a company grows, this area must grow as well, and it can consume a high percentage of revenue in terms of both equipment and people. Outsourcing can be much less expensive. For example, think of medical billing services for a chain of physician clinics or a purchasing department for a growing parts supplier.
Outsourcing also can alleviate the need for bigger, more expensive office space. Also, there is more flexibility in bringing in people when you need them.
Tough Personnel Decisions
Sometimes, doing a thorough cash flow analysis and developing a clear financial statement can ultimately lead to the conclusion that the current course is not sustainable. That can further lead to deciding to cut expenses, outsource some work and, in some cases, reducing staff.
That’s one of the most difficult decisions a business owner can make. Most managers and owners find it extremely distasteful and fear doing it, according to an article in the Harvard Business Review. However, it can be done in a respectful way that treats an employee with dignity, such as giving the news in a quiet, isolated place and in a direct manner. It should not be a drawn-out affair, but handled quickly. Business owners and managers should avoid getting sidetracked into personal issues, debates or arguments.
Hopefully, situations such as layoffs will not arise. Getting a good grip on costs is a major step in avoiding such an outcome. It will prevent a business owner from hiring more people than he or she needs or spending too much on equipment and supplies.
It’s impossible for a business to move forward without understanding the current state of finances. Getting a handle on costs is a large part of ensuring steady, consistent growth.