It’s been about eight months since I last got together with Mike, the M&A advisor who oversaw my business transaction that closed in October 2017. Mike and I went for dinner a couple of weeks ago.
Mike said something during our conversation that I thought I would share. He said, “I’ve been overly impressed with the accounting and financial knowledge of all of the CEOs who I have met, and worked with, over the last few years. It seems like the bar has definitely been raised.”
That’s rather ironic, I thought, as I’ve been particularly dismayed by the lack of accounting knowledge of the entrepreneurs who I have met over the last year.
Mike works for a large accounting firm that has an in-house M&A shop. He generally meets with firms that have more than $10 million in revenues and, in most cases, significantly more.
How is it that we have completely opposite perspectives on the same issue?
I work with and receive many emails from, entrepreneurs who are running businesses with less than $5 million in revenues, and many of these small business owners have very little knowledge of basic accounting fundamentals. As a result, I spend a significant amount of time in our early conversations reviewing the accounting basics.
I suggested to Mike that it isn’t a coincidence that the larger the firm, the more likely it is that the business owner will have a handle on the accounting. Or conversely, if they don’t understand the accounting, there’s a strong chance the entrepreneur won’t grow their business.
Knowledge of accounting isn’t a prerequisite for being a business owner. Knowledge of accounting is a prerequisite if you want to grow your business north of $3 to $5 million with 12–15% (or greater) EBITDA margins (see below for more on EBITDA). You don’t need to be a CPA, but you need to understand some basic accounting fundamentals and ratios. If you don’t understand the concept of 15% or greater EBITDA margins, then you have some learning to do.
Of course, for starters, you need to be able to read and understand your income statement, balance sheet, and cash flow statement. You also need to understand, track, and benchmark some key accounting ratios.
Produce Monthly Accrued Statements
One more thing … you need to produce, and review, a monthly accrued income statement, and balance sheet. This means that all revenues and expenses are lined up in the same monthly reporting period. For example, if your firm sold a $10,000 widget in the month and the cost for the widget was $5,000, then the revenue and associated expense must be reported on in the same monthly period, generally when the product is shipped or installed.
When you have accrued financial statements, you will be able to compare the overall trends for your KPIs (key performance indicators), which are now more meaningful. If you notice that monthly net income is trending downward, for example, you’ll be able to catch and, hopefully, pinpoint any changes that might have happened in your business.
I like to call the alternative (non-accrued and reviewed statements) the income statement surprise Go ahead, ask your accountant or controller for your latest YTD (year to date) income statement, and then ask for the monthly income statements for the last six months.
Is your income lumpy? Does the income shoot up one month and then down remarkably the next? If it does, how can you compare your current month to your prior month’s business activities? And then, how do you measure the health of your business? That’s why I call it the income statement surprise … because you don’t know what you’re going to get.
When I review an income statement for the first time, here are the top few things I review:
Gross Margin (GM):
Gross Margin is the first thing I look at. In the widget example I provided above, I explained that the widget sold for $10,000 with a cost of $5,000.If the company sold 10 widgets with a 50% gross margin, the income statement would look like this:
Revenue Widgets = $100,000
COGS (Widgets) = $50,000
Gross Profit = $50,000
Gross Margin = Gross Profit ÷ Revenue = 50%
Obviously, the higher the gross margin, the better.
Your businesses gross margin will speak to the health of your business, and if you’re comparing accrued monthly income statements for many months, you will notice trends before they become a problem. For example, if you have a declining gross margin, this will become apparent on a comparative basis. Poor numbers for one month aren’t necessarily a reason for concern, but if the pattern is sloping downward, then it’s possible that margins are being compressed, or you could have a salesperson who is selling your product too inexpensively.
EBITDA and EBITDA Margin:
Once I’ve reviewed the gross margin, my eye scans toward the bottom of the income statement, and I look at two items: EBITDA and EBITDA margin. EBITDA is earnings before interest, taxes, depreciation, and amortization, and the EBITDA margin is the EBITDA divided by the total revenue. Continuing from the example above, the (simplified) income statement now looks as follows:
Revenue Widgets = $100,000
COGS (Widgets) = $50,000
Gross Profit = $50,000
Operating Expenses = $40,000
EBITDA = $10,000
The EBITDA margin for this business is $10,000 ÷ $100,000 = 10%
Once again, the higher the number the better. A healthy EBITDA margin for a services business is in the 13–16% range, however, I’ve seen businesses with EBITDA margins in the 25% and even better range.
Now that I’ve looked at the gross and EBITDA margins, I want to know how the business is doing in regards to being able to cover its current financial obligations, and I’m now going to head over to the balance sheet.
Current Ratio: Another Important Financial Ratio for Small Business
Does your business have enough cash to meet its short-term financial commitments? Your current ratio, sometimes called the working capital ratio, will help you answer this question. You divide your current assets, such as cash, inventory, and receivables, by your current liabilities, such as a line of credit, current portion of long-term debt, and payables. It looks like this:
Current Ratio = Current Assets ÷ Current Liabilities
Let’s say you have $100,000 in current assets and $60,000 in current liabilities. Here’s how the formula looks:
$100,000 ÷ $60,000 = 1.66
Once again, the higher the number, the better. A ratio under 1 indicates that the debts due in a year or less are greater than the assets (cash or other short-term assets expected to be converted to cash within a year or less). A ratio greater than 2, or even 3, suggests that your business’s cash and receivables should more than cover your payables
I’ve listed three ratios—gross margin, EBITDA margin, and the current ratio—all of which can provide an indication of the overall health of your business, but these aren’t the only ratios you need to review. I look at many others, some of which I will review in another post, but the three I have reviewed here are the top ones I focus on when I want to get a quick gauge of how a business is doing.
If you’re not keeping track of any of these financial ratios for small business, or if you don’t know your business’s numbers from memory, then you need to spend more time with your financials.
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Here’s an interesting post I wrote: The Top 2 Mistakes I Made When I Started My Business. That Was a Long Time Ago, and Entrepreneurs Are Still Making the Same Mistakes Today
Here’s one of the first articles I wrote: My Journey Post Business Sale as I Sail Into a New Harbour.
Are you a younger entrepreneur? Here’s another interesting article I wrote:
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