Business Health Check: Key Questions to Ask Yourself.
Many businesses meet their demise due to the lack of a clear understanding of its financial health. Business owners may believe they have a handle on their business' financial health, but how certain are you that your visibility is crystal clear? The reality is, without effective financial management strategies, your business can quickly run into financial troubles and how would you know where to focus your efforts without a clear view of your financial health?
We dive into 6 key questions to ask yourself to assess how well you understand your business' financial health and position regarding profitability and cash generation.
Understanding Your Business's Profitability
To gauge the true profitability of your business, it's imperative to delve deep into the financial intricacies that shape your bottom line. Beyond the surface level of revenue and expenses, you need to understand the underlying factors driving your profitability to be able to manage those drivers. How is this done? Through analyzing your cost structure, margin drivers, and reflecting on actual results.
Q1: Do I understand the business’ cost structure and what drives those costs?
Your cost structure is essentially a comprehensive breakdown of all the expenses your business incurs, categorized by type and their interrelation, all of which significantly affect your bottom line. Understanding your business's cost structure provides the financial clarity needed to set prices, monitor expenses, optimize profit margins, and find cost-saving opportunities that ultimately determine the success and sustainability of your business.
Many businesses focus on overall costs but overlook profitability at a project or product level. Insight into your cost structure at a project or product level will enable you to spot underperforming products or services and also help you double down on your best performers.
Q2: Do I know what drove my biggest gross and net margin movements over the past year?
Was it the change in volume of sales, or price increases, or discounts? How sustainable are these methods for future profitability? What could potentially drive your margins further down or up? What are your biggest cost drivers and how can you control those drivers? How much profit did you make on each of your 10 largest customers?
Assessing your revenue sources and their sustainability is vital while understanding what moves your margins is a key element in understanding the long-term financial viability of your business. Take the time to understand what drives the margin in your business and what impacts it most.
Q3: Am I reflecting on actual results as a basis for planning my next moves?
Regular financial analysis allows you to spot trends, assess the impact of your decisions, and adjust your strategies accordingly. Incorporating core financial ratios and income statement trend analysis in these reviews can highlight opportunities for corrective action before issues become ingrained.
Reviewing historic results at least quarterly in conjunction with 3 to 7 key financial ratios that will show your business health is crucial for maintaining a proactive stance in managing your business's financial well-being.
Cash is King: Is Your Business Generating Cash or Is It Using Cash?
A cash-healthy business is one that consistently generates more cash inflow than outflow from its operations, ensuring it has adequate liquidity which can be used for reinvestment in the business, debt repayments, or dividend payments to investors. Your business might be profitable, but not generate cash and instead require continual cash injection to keep operations going. This situation will impede growth. A consistent failure to generate positive cash flow can also severely limit your ability to secure credit or financing, as potential lenders often view this as a sign of financial instability, potentially disqualifying your business from crucial funding opportunities for growth. To be able to consistently generate cash, you need to effectively manage your cash flow.
“Never take your eyes off the cash flow because it's the life blood of business.” – Richard Branson.
Q4: Managing Your Cash Gap: Do I know what the business’ average “cash gap” is?
A cash flow gap is the time between paying for something and getting money in return. Understanding your cash gap and aligning it with what is “normal” for your industry, is so important.
When your cash inflows and outflows aren’t aligned, you leave your business vulnerable to a cash shortfall. A prolonged cash flow gap increases the likelihood of your business depleting its cash reserves, jeopardizing its ability to meet operational expenses. A lack of awareness and understanding of your cash flow gap prevents you from recognizing when it becomes excessive and from implementing more effective cash management strategies to mitigate it.
The ideal cash gap for any company is a careful balance of strategy, industry dynamics, profitability, and operational efficiency. Achieving the best balance for your company begins with understanding your business’ current state and identifying opportunities for improvement. This underscores the importance of ongoing performance measurement and tracking to ensure your business remains financially resilient over time.
Q5: Do I know how much cash is tied up in the business’ working capital right now?
To effectively manage your cash gap, it's crucial to grasp the amount of cash tied up in inventory and unpaid invoices, as well as how long it's expected to stay tied up. Having an excessive amount tied up in unpaid invoices can potentially cause cash flow issues, necessitating an injection of funds into your business. By understanding this, you can plan ahead to secure credit or additional cash when needed.
Q6: Do I know what drives the business’ cash flow patterns?
It's important to recognize the factors that shape your cash flow patterns, whether they're linked to seasonal trends or the way your customers pay you. It not only helps you understand your ability to financially manage the business day-to-day but it also helps you understand seasonality or other cyclical ebbs and flows of cash in the business. By understanding those ebbs and flows, you can make more informed decisions, such as considering the addition of new product lines or services to stabilize your cash flow. If you have extra cash on hand, it can guide you in deciding when to distribute profits or reinvest in your business. In situations where you face a cash shortage, you may need to explore options like revolving lines of credit. To secure such financing, you'll need to demonstrate to financial providers that you have a firm grasp of your working capital and cash flow patterns.
Conclusion
How many of these questions can you confidently answer with your current financial information? If your response is "all of them," then you're likely maintaining thorough oversight of your finances and diligently tracking your financial performance. However, if any question remains unanswered, action is needed.
