I think it’s safe to say that most new business owners don’t jump into their entrepreneurial dream because they are financial experts or are particularly excited about spending a lot of time knee deep in their business’s financial reports.
But, it is important to understand what’s going on within their business—it’s really the only way to plan for growth.
Whether you’re simply trying to scale your business or seeking equity investment, having a plan is key.
Recently, Barbara Corcoran, entrepreneur and Shark Tank judge, shared some of her insights on small business. Tim Berry, founder of Palo Alto Software and Bplans, asked, “What’s the best way for entrepreneurs to demonstrate that they’ve thought through the essential aspects of their business, especially the financials?”
I can’t think of too many people more qualified to answer this question from the investor’s perspective.
“When pitching a potential investor, it’s important to have a complete understanding of your company’s financials and prospects.
The best way to demonstrate this is to become intimately familiar with your financial position—be able to explain your statements inside and out and even more importantly, illustrate the thinking behind the projections.
When you display a command of the financials, it instills a great deal of confidence in potential investors, because they feel you will show the same respect and concern for their cash investment too.”
Many lenders feel the same way. I have a friend who once said: “If I can tell more about a business’s health by looking at the financial reports than they can, I’m not likely to approve their loan request.”
3 keys to demonstrating that you know your business inside and out
In a nutshell, Corcoran suggests that you need to be “intimate” with how your business is doing financially as well as understand what potential opportunities or challenges you see for the future (a SWOT analysis can be helpful here).
1. Do you have a plan?
Let’s start with your “prospects.”
When Corcoran suggests you need to “…have a complete understanding of your company’s…prospects,” she’s alluding to a business plan and the potential your business has for future growth. It’s not uncommon for many business owners to rely on informal plans or Lean Planning to map out the future of their business.
The idea of a formal, written plan can feel like a lot of work with minimum benefit, but I don’t believe that’s the case. What’s more, a formal plan doesn’t necessarily mean cumbersome. A formal business plan can be a great tool for businesses at any stage of development—not just for startups looking for capital. Your business plan can and should be the platform for understanding and leveraging your financials and comparing actuals with your projections.
Many business owners fail to see the value of regular planning and forecasting, and it hurts their businesses because they haven’t planned for potential challenges and don’t have any kind of strategy for dealing with them. The same is true for opportunities. Planning for how you will take advantage of opportunities for growth could even be vitally important as you work to build a healthy and thriving business.
2. Do you regularly review your plan?
If you do devote the time to crafting a well thought out business plan, how often do you revisit it? I believe your business plan should be a living document that you regularly consult (think at least quarterly) to measure how you’re doing today versus what you forecasted in your plan. Big businesses devote time to regular planning and reviewing their actual performance to the plan as part of how they measure success.
A big part of your plan review should center on financials—comparing your actual performance with what you forecasted. If doing this on a regular basis sounds daunting, using a dashboard that integrates with your accounting software to track your financials can make it easier.
Regular planning helps businesses to take advantage of opportunities within their markets. I believe this is a big business behavior small businesses should be modeling. Nevertheless, your business plan should be a living document you can review regularly, and not something so unwieldy that it gets put on the shelf and never referenced again.
What’s more, when an investor asks to see your plan, they are likely even more interested in how your business is performing against that plan.
For more on how to hold a monthly plan review meeting, see this article on the LivePlan blog.
3. Do you work on your business, or in your business?
According to the SBA, roughly two-thirds of business with employees survive at least two years, and only about half make it to their fifth birthday, so it’s important to understand what it means to work on your business.
With that in mind, there are a number of reasons many small businesses seem to fail, for example:
- There’s not enough demand for their goods or services
- Growth is out of control
- They are undercapitalized
- They aren’t well run
- They are inefficient
- Their market is in decline
- They have poor accounting practices
- They fail to adequately plan
- Myriad other reasons
Michael Gerber, the author of the “E-Myth Revisited,” suggests that there is one primary reason many businesses fail:
“Most entrepreneurs are merely technicians with an entrepreneurial seizure. Most entrepreneurs fail because you are working in your business rather than on your business.”
You don’t really need to be a financial expert or an accountant to work on your business, but there are a handful of financial metrics that will help you better understand your business financials and make it easier for you to demonstrate to a potential investor that you’ve got a handle on the important metrics associated with running a successful business.
Keep an eye on these important metrics
As a small business owner, I found these metrics to be crucial to understanding the health of my business from a financial perspective.
Without revenue, nothing else in your business can really go very far. When talking to any investor (or a lender for that matter), be prepared to talk about your business’s revenue and growth.
I tracked this number on a daily, weekly, monthly, quarterly, and annual basis so I could compare how my business was doing today to last year, last month, last week, and so on.
There are several ways to categorize your expenses, and your accountant can help you decide which is best for your business, but you need to have a thorough understanding of what it costs you to do business to demonstrate your profit-earning potential to a prospective investor.
Don’t forget, an investor may not be looking for a regular loan payment (like a bank or other lender), but they are looking for a return, so showing you have expenses under control is a first step to demonstrating you are (or can be) profitable.
3. Cash flow ratio
Poor cash flow has been the death of many small businesses, so it’s critical. It’s not enough to know that you have money in the bank at the end of the month; you need to understand the ratio and what it’s telling you.
Your accountant will tell you that your cash flow ratio is obtained by dividing your assets and your liabilities. The ideal, or the goal for every business owner, should be a ratio of 2:1. Or, twice as many assets as liabilities. For most businesses, that’s a pretty tall order, but anything below 1:1, should be a big red warning flag that your business doesn’t have adequate cash flow to maintain business operations.
4. Accounts receivable aging
How long does it take your customers, to whom you offer credit terms, to pay their invoices? If you offer 30-day terms, do they consistently pay in 30 days or do they sometimes go 45 or 60 days?
I found that there was a point where it actually cost me to do business. If a customer went over roughly 65 days, the negative impact on my cash flow basically chewed up any profits that I might have earned. What’s more, for every day over 45, it became exponentially more difficult to collect. This is a metric you just can’t ignore.
5. Accounts payable aging
This is another number you should have at your fingertips, and how you manage your accounts payable could help you capture an additional percentage or two of profit.
For example, because many of your vendors and suppliers that offer payments terms, also offer what is often called a prompt payment discount, if you pay in 10 days instead of the 30 days, you could capture an additional percent or two discount on your invoice. It also demonstrates to creditors and potential investors that you are capable of managing your financial obligations.
Establishing some rigor regarding planning and setting aside time to address the financial side of a small business can initially seem like a lot of extra work for a marginal return. But actually, it’s what sets those entrepreneurs who work on their businesses apart from those that simply work in them. Regular analysis and planning can be very attractive to investors, will also help build a healthy and thriving enterprise.