Growing a small business? Here are 5 financial equations you need to know
Cash flow may be the lifeblood of a small business, but the ability to create accurate projections and forecasts for your business is what moves it forward. Knowing what’s coming in and what’s going out, and being able to use that knowledge to plan and act is the only way a small business owner can effectively pursue and manage growth opportunities.
Creating accurate cash flow projections is a key tenet of the Goldman Sachs 10,000 Small Businesses program. By understanding the financial implications of a business growth plan, small business owners can estimate their funding needs, ensure operations are able to handle growth, monitor progress against critical variables, and make real-time adjustments. Here are five key metrics small business owners need to know when developing their forecasts.
1. Profit Margin = Net Income ÷ Sales
Your profit margin refers to how much money you get to keep after selling your products or services, accounting for initial outlay and investments. The amount of profit may vary from product to product and should reflect the total amount of cost outlay, labor and a small percentage of overhead. When it comes to forecasting, your profit margin helps you anticipate how much money will be coming in in the future, especially when matched with your asset turnover (see metric number 4).
2. Current Ratio = Current Assets ÷ Current Liabilities
Your current ratio tells you if you have enough money to pay off your short-term debts. In general, the higher the ratio, the better the financial health of your company, although you can have too much in cash. By knowing this ratio, you can see if you may be facing any capital emergencies, or — if you have a higher ratio — if you have capital available to reinvest in other parts of your business.
3. Asset to Equity = Assets ÷ Shareholders’ Equity
Your asset to equity ratio tells you how your business is being financed—either by loans or by positive cash flow. The higher the ratio, the more your business is being financed by debt.
4. Asset Turnover = Sales ÷ Assets
Your asset turnover measures how quickly you are able to sell your products. If your capital is tied up in unsold inventory, you can’t invest it in other areas of your business. The higher the asset turnover ratio, the better return you are receiving on your money. An accurate view of how long your capital will be tied up in certain stock items can help you see your true financial picture and also forecast what capital will be available and when.
5. Payables Period = Accounts Payable ÷ Credit Purchases per Day
Your payables period is what you owe (vendor payments) and what you are owed in return (client invoices). Daily updates of what you have due to come in and to go out will help you form a clearer picture of your business’ health and avoid a cash crunch.
Robust cash flow metrics are critical to accurate cash flow projections and provide you with a sound understanding of the fundamentals of your business. By knowing the details of your cash flow you can efficiently run your day-to-day operations and confidently respond to new business opportunities.
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