Improving Financial Planning
Financial planning affects how and on what terms you will be able to attract the funding you need to establish, maintain, and expand your business. Financial planning determines the human and physical resources you will be able to acquire to operate your business. It will be a major factor in whether you will be able to make your hard work profitable.
The balance sheet and the income statement are essential to your business, but they are only the starting point for successful financial management. The next step is called ratio analysis. Ratio analysis enables you to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry. To do this, compare your ratios with the average of other consulting services as well as with your own ratios over several years. Ratio analysis can be the most important early warning indicator for solving business problems while they are still manageable.
How can I know what my financial statements should look like?
Members of trade associations will often share their balance sheet, income statement, and management ratios with other members through studies and reports published by the association. These percentages can help you to determine whether your consulting services business is being operated as efficiently as other firms in your industry.
The language of business is math. Mathematics is used to measure income, expenses, profits and losses, taxes, and every other aspect of conducting business. So it is no surprise that ratios are also important.
A ratio is the relationship of two or more measurable things. Ratios help you compare. Imagine that your business ratio of sales to profits is 10:1 (ten to one). On average, every $10 in sales earns $1 of profit. You now want to know how that ratio compares to the sales-to-profit ratio for similar businesses. Going deeper, you may want to compare the COGS ratio or the sales expense ratio for your business to others.
Just as important, investors and other financial people look to ratios to diagnose your business. They may decide to only invest in businesses that have a specific earnings ratio or asset ratio. So it's important that your business understands how ratios work. Important balance sheet ratios measure liquidity (a business's ability to pay its bills as they come due) and leverage (measuring the business's dependency on creditors for funding). Liquidity ratios indicate the ease of turning assets into cash. They include the current ratio, quick ratio, and working capital.
The current ratio is one of the best known measurements of financial strength. It is calculated as follows:
The main question this ratio answers is: Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety? Let's say that you or your lender decides your current ratio is too low. What can you do about it?
Pay some debts.
Combine some of your short-term debts into a long-term debt.
Convert fixed assets into current assets.
Leave in earnings or put profits back into the business.
Increase your current assets with new equity (bring more cash into the business).
The quick ratio is sometimes called the acid test ratio and is one of the best measurements of liquidity. It is calculated as follows:
The quick ratio is a much more exacting measure than the current ratio. By excluding inventories (typically small in consulting services businesses), it concentrates on the really liquid assets with value that is fairly certain. It helps answer the question: If all sales revenues should disappear, could my business meet its current obligations with the readily convertible quick funds in hand?
Working Capital Ratio
Working capital is more a measure of cash flow than a ratio. The result of the following calculation must be a positive number:
Working Capital = Total Current Assets - Total Current Liabilities
Lenders look at net working capital over time to determine a company's ability to weather financial crises. Bank loans are often tied to minimum working capital requirements.
Nearly all businesses borrow money or have other forms of debt. Investors and bankers are often interested in what the level of debt to assets is for the business. Debt ratios measure the business' ability to repay long-term debt. A couple of popular debt ratios are:
There are many other debt ratios useful in business. Your accountant and banker can suggest the best ones for your business.
Profitability ratios are useful for ensuring that assets and expenses are well managed. Gross margin is a profitability ratio. Other useful ones include:
Profitability is the lifeblood of business. Profitability ratios can help you quickly take a business's pulse.
You can make a ratio out of any two numbers in your business. You can use a ratio of the people who call your business in comparison to those who buy your services. You can establish a ratio of newspaper to radio advertising dollars. The question is: Is it useful in measuring and managing your business? If it is, use it.