A recent research report from the Federal Reserve Bank of Chicago, Pepperdine University, and online small business lending company FundWell raises awareness about small business financial health. The report titled, “Small Business Financial Health Analysis” covers policies, investments, and financial and technical assistance resources to help small businesses achieve their goals in computing their financial health.

But, these three institutions came together for another important reason. Our U.S. economy depends on small businesses to be financially healthy. There’s no denying that small business growth drives U.S. job creation. From 1993-2009, the U.S. economy added 9.8 million jobs! A financially weak business creates a domino effect – impacting the U.S. economy.

To ensure businesses are financially healthy, we need to give them (that means you!) the tools they need.

The study, based on 940 small business owners, concluded that “small businesses that had a better understanding of asset based financing, including inventory financing, accounts receivable financing, trade credit, and equipment leasing financing, scored higher on the [study’s pre-determined] financial health index.”

Over 33% of the businesses that had excellent financial health said they had a solid understanding of these asset-based financing products. Yet, over 33% of businesses with poor financial health said they had never even heard of or had limited knowledge of these four funding options.

The lower scores were mostly related to the amount of unused credit the small businesses had on their credit cards, the success they had in securing bank loans and other financing, and the number of full-time staff employed.

The study also found that female- and minority-owned ventures are far less likely to be in good financial health than their male-owned, non-minority counterparts.

Ultimately, the study found that “better financial planning and management contribute to a higher financial health score.”

Financial Health Tips

No one knows better than us that you have a lot on your plate already as the head of your company. You already have your hand in a lot of areas from HR to marketing to payroll. But, you need to make time to be on top of your financial health.

That study found that financially healthy businesses have three common factors:

1. They have a lot of financial knowledge on equipment leases.
2. They’ve secured financing from a bank.
3. They always develop a budget and manage a separate bank account for payroll.

Understanding your company’s finances and financial statements tells you what your business needs to survive and develop. Tools like iCFO help businesses understand financial literacy.

But you can boost your financial literacy level on your own. Here’s a list of critical measurements you should know: profitability, cash flow cycle, available liquid/near liquid assets and credit to fund operations/expansion, working capital requirements, and your personal credit score.

Financially healthy businesses also think before they buy. Take time to think before you buy that new 3D printer or cool industrial office space. Ask yourself, “Can I keep my business running successfully without these assets?” If the answer is yes, then pause on those fun things and instead, focus on increasing your cash flow. Cash flow is the amount of money coming in and out of your business.

Additionally, make sure to separate your business financials from your personal financials. This is a tricky situation that shouldn’t be taken lightly! If you’re depositing funds into your personal account, getting a business credit card or loan will be difficult. So, set up a separate business checking account and pay yourself a salary. When April 15 rolls around, you’ll be really glad you did this. The IRS will like it, too.

Financial Health Strategies

Now that you have our helpful tips, you are ready to start strategizing.

The first step in any good strategy is to begin planning. Set objectives for your business’s financials. There’s a second step to this that’s really important – you must measure them! Take the time to set goals, such as revenue targets or acquiring new clients. Next, set a one-year plan, three-year plan, heck – you could even set a ten-year plan.

When you develop a plan, you can pinpoint where your strengths and weaknesses lie. And, using tools (like iCFO), you can benchmark your performance against your industry peers. This will afford you valuable information signifying if you should refocus your efforts – or stay put.

If you’re an entrepreneur, have cash reserves. If you’re starting your own business, it’s best to have six months of reserves. Analyze your personal budget and evaluate what your monthly expenses are. Your reserve of cash should cover these expenses during a slow period. Continue to think ahead and evaluate your budget to stay on top of your company’s financial health.

Check your finances monthly and keep track of these records. At the most basic level, you need three financial statements to assess your financial health: a balance sheet, cash flow statement, and profit and loss statement.

Get very comfortable with these statements because you are going to be visiting them every month! A balance sheet evaluates your assets, liabilities, and net value.

A cash flow statement, or statement of cash flows, reports cash that is generated and used during a specified time period. It shows how cash is generated and used in these activities: operating, investing and financing. The cash flow statement also shows the amount of income taxes and interest your company has paid.

The profit and loss statement is a snapshot of your financial health. It measures how much your business is spending compared to what it’s earning.

Financial Health Ratios

There are about 20 financial ratios you can compute to identify if your company is financially healthy. Let’s go over the top 5 financial health ratios:

1. Quick Ratio

This is a quick and easy calculation and the result is easy to understand, too. The goal of computing this financial health ratio is to see if your company has enough cash, assets, and low debt to operate – without running into financial trouble.

Quick Ratio = (Current Assets-Inventories) / Current Liabilities

2. Debt/Equity Ratios

This determines how your business has been financing its growth.

Total Debt/Equity Ratio = Total Liabilities / Shareholders Equity

A high result means your business has been growing due to debt. But, remember – not all debt is bad. If the result is really high, your business has to pay off loans and interest payments.

3. Current Ratio

This balance sheet ratio is very common. It’s used to determine your business’s ability to pay back its short-term liabilities.

Current Ratio = Current Assets / Current Liabilities

If the result is less than 1, that’s a warning sign as to whether your company is able to pay its short-term obligations. It doesn’t necessarily mean your company will go bankrupt, but it’s something worth keeping tabs on.

4. Days Sales Outstanding

This ratio shows how well your business can convert its receivables into cash. A business that can do this quickly is financially healthy.

Days Sales Outstanding = (Receivables / Revenue) x 365

You want to see a low number here – this means it takes your company fewer days to collect your accounts receivables.

5. Days Inventory Outstanding (DIO)

This financial health ratio calculates the average number of days a company holds inventory before they sell it.

Days Inventory Outstanding = (Inventory / COGS) x 365

This is an industry specific ratio that’s used to compare your company to your competitors.

Financial Health Checks

Just like your annual physical at the doctor, your company deserves an annual financial health check.

Review Your Goals
Did you meet all the goals you outlined in your one-year business plan? Business planning is not a once-a-year event. That’s why it’s pertinent to check your progress to date and make sure your action items are being met along the way. Implement quarterly reviews of your company’s strategic goals and targets.

Is There an Opportunity for Growth?
Remember those financial statements we went over in our “Financial Health Strategies” section? Those come in handy when you’re looking at opportunities for growth. Each year, analyze those financial statements with your financial goals and projections in mind. The analysis provides valuable insight on how your goals should adjust for the following year.

Succession Planning
It’s important to plan for life’s unexpected events. You need to plan for for financial hardship, injury, disability and even…death. Sorry to get so morbid on you, but you’ve already invested so much time into making your business successful. To make sure all of your hard work doesn’t go to waste, develop a plan for the succession or transfer of ownership of your company.

While an annual physical at the doctor is recommended, so is seeking care when you need it. Annual and monthly financial statement analysis is necessary to review your company’s financial health. However, if you think your company’s finances need attention at any time, evaluate your business’s financial health using our tips, strategies, ratios, and checks.