Owning and running your own business is a risky affair. Some businesses thrive, others flop, and many other businesses meander between these two statuses depending on consumer trends, price pressure and seasonality.
The reality of being a business owner is dealing with the many, often conflicting, signals from financial and anecdotal data which is being constantly created.
On the exterior, a manufacturer might be dispatching a record number of orders, but financially it could be short of cash and facing bankruptcy within weeks.
A cafe might be visibly full and carrying on a brisk trade but making a loss each week that it is open.
On the flip side, a relatively quiet business may be enjoying its strongest financial performance yet due to cost-control measures.
We hope these examples show that no single measure of business performance will give a reliable indicator of whether your business is succeeding or whether it’s running out of the road. In this article, we’ll rank the most important signals that you should be monitoring to avoid insolvency.
Monthly free cash flow generated from operations
The single most reliable indicator of business performance is the cash that it generates.
However, you shouldn’t look at the total measure, but rather just the cash generated from the operations of the business, i.e. selling to customers and paying suppliers and employees.
Cash flows can be generated from one-off sales of equipment or receipts of investment money or loans. However, these don’t provide any insight into the ability of the company to make money over the long term, so these are excluded from this metric.
We encourage this figure to be looked at every month, because a more frequent weekly or daily metric may not capture periodic costs such as salaries or monthly utility bills, so could give a distorted picture depending on precisely which costs were included. A monthly snapshot will likely include a representative mix of expenses.
Working capital can be measured in a few ways, but we suggest adding your cash and trade receivables, and then deducting your trade payables and other short-term payables.
This gives a sense of the amount of cash or other highly liquid assets you have available, on hand, to settle an unexpected or large expense.
Companies purposefully try to maintain a lean amount of working capital on hand, as this reduces the amount of capital an owner or investor needs to physically give to the company to fund its operations.
However, when working capital becomes very low, or even negative, this serves as a warning indicator that the business could encounter cash-flow issues and could even become unable to pay suppliers on time.
Profit before tax
The first two measures have focused on cash. Cash is ultimately the lifeblood of a company and is the only protection against bankruptcy. However, accounting profit is also a useful companion to cash flow measures.
Accounting profit is designed to accurately show how much profit is being made by attributing costs to the revenue that it helped to generate. In practice, this may mean deferring incurred costs into a future accounting period, or taking the profit hit before you’ve even paid for liability, but this is done with consistent accounting principles to produce an insightful and comparable picture of performance.
Due to different payment deadlines, and seasonality in a business, the operating cash flow of a company can differ quite substantially from its underlying profitability. In some cases, a business could appear to be generating cash, but its management accounts will reveal that it’s operating at a loss.
Without a profit and loss statement, the business owner could be lured into a false sense of security that their business is running as expected when this was being superficially inflated by large customer payments or a delay in payments to suppliers. Accounting profit gives the most accurate x-ray into revenue and costs to answer the question – are we bringing in more money than we’re spending?