7 essential questions to assess your small business’s financial health

Understanding the true financial standing of your business goes far beyond simply looking at your sales figures. High revenue can be deceptive, masking underlying issues that might compromise your company's long-term viability and attractiveness to investors.

A truly healthy business is built on a solid financial foundation. To check the strength of that foundation, you need to dig deeper into your financial data and ask some critical questions.

Answering these questions provides a comprehensive check-up of your company's financial health. This process will uncover key metrics related to your profitability, spending habits, debt management, and inventory efficiency, paving the way for a more resilient and valuable enterprise.

Here are seven essential questions every small business owner should ask.

1. How healthy are your profits?

Impressive sales numbers are exciting, but they don't tell the whole story. The real measure of your financial success begins with profit. You can calculate your basic profit by subtracting your operating costs from your total revenue.

However, simply glancing at your profit on a financial statement offers a very narrow perspective. It's a single data point in a much broader financial landscape. A comprehensive assessment requires looking at profitability from multiple angles to understand what’s really driving your business forward.

2. What are you spending on sold goods?

To truly understand profitability, you must first analyze your spending. The Cost of Goods Sold (COGS) is a crucial metric that reveals exactly how much you spend to produce the items you sell. It represents the direct costs of acquiring or manufacturing the products sold to customers.

Calculating COGS is straightforward:

COGS = Beginning Inventory + Inventory Purchases – Ending Inventory

This figure is more than just a number on a page. When analyzed alongside other business metrics, COGS helps you pinpoint the ideal pricing for your products, gain a clearer view of your company's overall financial performance, and assess the profitability of individual items.

Manually tracking all the invoices and receipts that contribute to these costs can be a significant challenge. To streamline this, you can use a service like Zenceipt, which automatically connects to your email inbox to find and process accounting documents. This ensures your financial data is always up-to-date and accurate, making calculations like COGS much simpler.

3. How much are you earning from each sale?

Once you know what you're spending, you can determine what you're earning on each sale by calculating your gross margin. This metric, found on your income statement, shows the revenue generated before accounting for business expenses not directly related to COGS.

The formula for gross margin percentage is:

Gross Margin % = (Revenue – COGS) / Revenue

This percentage reveals how much money your company keeps as gross profit from each dollar of revenue. For example, a 15% gross margin means you retain just $0.15 for every dollar in sales. To see this as a dollar amount, you can calculate the gross profit directly:

Gross Profit = Revenue - COGS

Analyzing your gross margin is critical for a small business audit. It helps you assess your operational efficiency, predict the funds available to cover additional overhead, and make informed pricing decisions. A declining gross margin can be an early warning sign of financial trouble, suggesting it might be time to reduce labor costs or find cheaper materials.

4. What is the bottom line?

Your gross profit is a key component in figuring out your net income, which is the ultimate indicator of your business's profitability. Net income shows you how much money is actually left for you or to reinvest back into the business after all is said and done.

To see the complete picture of your profitability, you need to calculate your net income:

Net Income = Gross Profit – Operating Expenses

This calculation accounts for all the cash flowing in and out of your business. While it doesn't provide a granular view of every financial detail, it answers the most fundamental question: are you actually making money?

5. What is your relationship with debt?

Few businesses grow without some form of financing, and taking on a small business loan is a common step. However, it's essential to manage that debt responsibly. A key metric for assessing this is the debt-to-total-assets ratio, which shows how much of your company is financed through debt.

You can calculate it with this formula:

Debt to Total Assets Ratio = Value of Debt / Value of Assets

A lower number is generally better. As a point of reference, investors tend to favor businesses with a debt ratio between 0.3 and 0.6. A company with a higher ratio is often seen as a riskier, less financially stable investment.

6. Is your inventory actually moving?

Products sitting on a shelf aren't making you money. A high inventory turnover rate is a sign of strong sales and healthy demand, while a low turnover rate suggests sales are weak or you have too much stock.

You can assess your inventory management by calculating your inventory turnover rate.

• Step 1: Calculate Your Average InventoryAverage Inventory = (Current Inventory + Previous Inventory) / 2
• Step 2: Calculate Inventory TurnoverInventory Turnover = COGS / Average Inventory

This rate is a vital piece of information for managing and replenishing your stock effectively, ensuring your cash isn't tied up in slow-moving products.

7. Do you have a safety net?

A simple yet effective way to gauge your financial health is to consider your preparedness for the unexpected. If a sudden, large expense were to arise, would you have the funds to cover it without derailing your operations?

It is highly recommended to maintain an emergency fund equivalent to at least three months of business expenses. If paying for an unforeseen cost would put your business in a precarious position, it's a clear signal to re-examine your finances and identify areas where you can reduce expenses to build a cash reserve.

Ultimately, the most effective way to monitor your company's financial health is through diligent and consistent financial tracking. Regular bookkeeping not only helps you understand your business's performance but also allows you to identify potential red flags before they escalate into serious problems.