Improving your financial strength

Financial strength looks at how well your business is being run and how to cope if business conditions become difficult. Therefore it is important to have visibility over your finances through good, consistent accounting practices and effective management of business cashflow.
 

Some key indicators include your:

• Financial return on the amount of effort and how much money you have tied up in the business. For example, if you have net assets of $1m, dividing the yearly net profit will give you a percentage. If it’s lower than what you could invest the $1m somewhere else, maybe you should rethink your strategy (this excludes any salary or wages you’ve allocated to yourself).
• Proportion of the balance sheet that is borrowed and your ability to pay this back over time. 
• Makeup of working capital, which covers how much money you have tied up as stock, cash in savings, your efficiency at collecting debts and how quickly you pay suppliers.
• Current ratio, calculated by dividing your current assets (cash, stock, accounts receivable) by current liabilities (short-term loans, accounts payable). You’re aiming to have more assets to cover your liabilities.
• Rate of stock turn, by dividing the cost of goods sold by the average stock, telling you how fast your stock is turning over (the higher the better, indicating stock is coming in and then being sold faster, with less out-of-date or poor selling stock).
• Equity to assets, calculated by dividing owner’s equity by total assets. A low ratio means your business may be undercapitalised, which can lead to unacceptable levels of risk, particularly if trading levels decrease, or you have significant levels of debt and borrowings to repay.
• Expenses ratio, worked out by dividing expenses into sales. Use this to check expenses are not ballooning ahead of sales (can often happen when growing and inefficiencies creep in).
• Average revenue per customer, which is the total revenue divided by the total number of customers. When you understand how much each customer is bringing to your business, you can focus on attracting more of them.

Building financial literacy
 

It’s easy to leave the number crunching to your accountant. Still, it pays to have a basic foundation of financial knowledge to give you greater visibility over where your business stands and help you make decisions that drive your business forward. 

To help build financial strength, you could:
 

Price for profit
 

Pricing your products and services so everything you sell makes a profit it crucial. You should develop your pricing through research and an understanding of both what your customer will pay, and your own operational costs. To create an effective pricing strategy:

• Figure out where you want to be positioned in the market and then set your business to justify your decision.
• Conduct market research to understand what your competitors are charging and what your target customer is willing to pay for a product or service like yours.
• Try to avoid pricing low unless it’s one of your main competitive advantages or you’re a new entrant to the market and want to win new customers.
• Always look at raising your prices to match inflation and costs of production.

Understand the difference between gross and net margins
 

A margin is the difference between the sales price and the cost of production or delivery. For example, buying in a product for $100 and selling for $180 will give you a gross margin of $80. But that’s before you deduct the selling expenses or overhead. Sometimes a high margin item may need people to support the sale, manage returns or queries, require customer on-boarding or instructions, where a low margin item may be plug and play.
 

The easiest way to improve margins is to:

• Raise your price, even by small amounts regularly.
• Lower costs associated with providing your goods or services by reviewing suppliers, agreements and wastage. Ensure this includes staff and service costs, not just the raw materials or origination costs.
• Amend your business model by moving to subscription services or new channels and focus on selling goods or services that offer you the best margin return.

Forecasting effectively
 

Being able to forecast cashflow accurately is essential for any small business, yet it’s often overlooked. With an idea of predicted income and expenses, you are in a better position to make financial decisions and ensure you’re not overstretching your resources. In addition, regular forecasting will give you greater visibility over the day-to-day finances of your business and allow you to be more strategic with your activities.
 

Use a spreadsheet or invest in easy-to-use accounting software, such as Xero and speak to your accountant if you need help to understand forecasting in more detail.
 

In summary, improving your financial literacy as a business owner helps prevent you from flying blind and encountering unexpected financial hurdles. With good accounting practices and systems in place, you can achieve visibility on where you stand today and how your numbers are looking tomorrow, allowing you to make more proactive and strategic financial decisions.

Next steps:
 

• Decide which parts of your business you believe need to be financially strong and set up metrics to measure every month. If any metric falls below a threshold, take action.
• Benchmark your business against industry metrics to track how you are performing inside the industry. For example, your business may be improving internally yet be below industry averages.
• Talk to your business adviser about setting up cashflow forecasts and reviewing your pricing and profit strategies.