The turn of the year is a time when fitness looms into view for most of us. With the guilty pleasures of holiday excesses a distant memory, thoughts soon turn to getting back into shape in order to face the year ahead. When it comes to financial fitness, however, a shocking number of small business owners head into a new year with little or no clue as to how good a condition they’re actually in.
That’s a situation we’ll set out to rectify in this piece. We’ll break down three key questions you can ask yourself as an entrepreneur in order to instantly assess your financial fitness. Each of them has the potential to steady the ship on its own. Answer them all in sequence, and you’ll be in a much better place than the vast majority of your peers.
Let’s start with the big one!
1. Do you know your break-even point?
A break-even point is a concept that’s often worryingly vague for many entrepreneurs, particularly among smaller outfits. It’s emphatically not a general feeling you’re over the hump for the year — it’s a very precise number you should use specific formulas to calculate in advance.
Before we hit the figures, let’s give a definition with a little help from our friends at the balance: a company’s break-even point is the point at which its sales exactly cover its expenses.
Now, let’s look at the formula:
Fixed Costs ÷ (Price – Variable Costs) = Break-even Point in Units.
As you can see above, you’re going to need three key pieces of information to do the math:
It’s the first two which are the blind spots for many business owners. To take a common example from the world of eCommerce, there’s potentially a huge number of online apparel firms that have only the flimsiest idea of how much returns are actually costing them.
By the time you gather the data and tot up the numbers, you should be looking at a number that’s either very reassuring or deeply worrying. Either way, it’s the number you need to hit as early as possible, so the sooner you know what it is the better.
2. How many months can you last if something goes horribly wrong?
Our accounting friends have a lot of three-dollar words to help talk about the question above in a little more detail. You’ll hear talk of contingency funds, liquidity, solvency and a host of other terms when the topic comes up. The nub of it all, though, is what happens if the wheels come off temporarily? Do you have enough money in the bank to make it through an unexpected rough patch?
As every business owner knows, the unexpected can — and does — happen.
If you’re sailing into the future blithely assuming that things will all magically pan out with no storms along the way, you’re asking for trouble.
Trouble can also arise in many forms: sales slumps, late payments, unexpected capital expenditures, increases in costs — they’re all going to happen sooner or later.
There’s no magic formula that applies to all businesses for setting up your contingency fund, so needs will vary. At a minimum, though, you should be in a position to make payroll and rent for two to three months if sales dried up today.
3. How quickly do you actually get paid?
Our final point is one that repeatedly catches a lot of first-timers out. Whether you’re in the products or services game, there can be a nasty gap between the euphoria of finishing a project or making a sale, and the money actually hitting your account. Remember, all the bank manager and the world at large really cares about is the latter event!
Again, there are various technical accounting terms and practices around the general subject of receivables that will help you dig into this in more depth.
Then, take a long hard look at your contracts and terms to tighten things up if necessary. As you grow, you’ll then want to make sure you more fully understand the underlying accounting principles involved in handling receivables.
What do you do once you’ve answered the questions?
As we’ve not so subtly indicated at various points above, there’s no real getting around the need to understand the basics of accounting. Though you can very easily set up a business without that knowledge, it’s a subject you need to tackle in order to effectively manage your financial fitness and cash flow down the line.
This isn’t to say you need to do your own accounting — far from it! You do, however, need to understand what’s going on beneath the hood. Accounting Coach is a godsend in this regard. The basics are comprehensive and free, and a one-time payment unlocks the premium package. If you’ve been dodging the general area to date, make this the year you finally knuckle down and add it to your overall skillset.
Embrace your financial fitness
Similarly to your physical health, your financial fitness as a small business owner can be boiled down to a set of relatively few questions. The three we’ve covered are by no means the only ones you should use, but they’ll help you get a read on what sort of overall shape you’re in.
Let’s recap those questions to close things out:
- Do you know your break-even point? Without this number, you’re flying blind.
- Have you established a contingency fund? If the answer is no, you’re running a huge risk.
- How long does it take you to get paid? Even completely healthy businesses can run into enormous difficulty if receivables get out of hand.
Step through the three questions above while sharpening your overall financial fitness, and you’ll find yourself in better condition than most.