Understanding revenue (recurring vs. one-time) and expenses (fixed vs. variable) is key to assessing business health. Profitability boils down to revenue minus expenses. We can delve deeper by evaluating:

Revenue Trends: Are sales consistent? Any seasonal dips or unusual returns?
Profit Margins: Are gross margins (revenue minus cost of goods sold) and net profit margins (considering all expenses) improving year-over-year? How do they compare to the broader industry?
Concentration Risk: Does the business rely heavily on a few customers or vendors?
Cost Management: Can we identify areas to reduce or better manage expenses (e.g., high SG&A costs)?
Profitability Ratios: How do metrics like profit margin ratio and break-even point look?

By analyzing these factors, we can assess a business's ability to generate profit and identify areas for improvement.

For more, check out this blog post!

Profit tells you if a business makes money, but cash flow reveals when that money comes in and goes out. A healthy cash flow ensures a business has enough funds to operate and grow.

We can assess cash flow by looking at its three categories:

Operating Cash Flow (OCF): This is the cash generated from core business activities (sales, expenses, payroll). A positive OCF is crucial, as it indicates that the business can cover its ongoing costs. We should also check for slow customer collections or high expenses impacting OCF.
Investing Cash Flow (ICF): This tracks cash used for long-term assets (equipment, investments). This is typically negative (investing in growth is good) but we need to understand if the business can't invest due to cash constraints.
Financing Cash Flow (FCF): This shows how a business raises or repays capital. Positive FCF can indicate debt reduction or issuing new stock, while negative FCF may show taking on loans. We should consider if this aligns with the business strategy.

Beyond these categories, three factors significantly impact cash flow:

Accounts Receivable (AR): High AR means slow collections, tying up cash.
Accounts Payable (AP): Utilizing vendor terms and negotiating for longer payment terms with suppliers can free up cash in the short term, but manage this strategically.
Inventory Turnover: High turnover indicates faster cash flow, while low turnover ties up cash and can lead to higher storage costs.

By analyzing these factors, we can assess a business's ability to manage cash flow and ensure it has the resources for future success.

See this blog post for more information!

Businesses use financial leverage (debt and other financial instruments) to potentially increase the returns their business generates. Leverage acts like a lever, where a small input can yield significant results, but magnify risks.

There are two main debt types:

Long-Term Debt (1+ year): Used for long-term investments like property (more flexibility for repayment).
Short-Term Debt (< 1 year): Used for day-to-day operations or unexpected expenses.
The key is finding the right debt balance. Too much debt can be risky, but a good strategy can accelerate growth. Several factors influence ideal debt levels:

Industry: Some industries (e.g., utilities) can handle more debt due to predictable cash flow.
Company Maturity: Younger companies may need more debt to grow, while established ones may have more flexibility.
Interest Rates: Lower rates make debt financing more attractive.

To assess financial leverage, we look at:

Financial Statements: Confirm revenue, cash flow, and identify interest payments.
Debt Analysis: Analyze total debt, structure (short vs. long-term), number of lenders, etc.
Leverage Ratios: Analyze debt-to-equity, debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), and interest coverage ratio.
Other Considerations: Interest rate risk, debt maturity, and industry / company-specific risks.

For more information on financial leverage, check out this blog!

Operational leverage analyzes how a company's cost structure, specifically the balance between fixed and variable costs, impacts profits.

Fixed Costs: These remain constant regardless of sales (rent, salaries, insurance). They create a baseline expense that must be covered even with low sales.
Variable Costs: These fluctuate with sales volume (raw materials, commissions, shipping). As sales rise, so do variable costs.

The Degree of Operational Leverage (DOL): DOL measures how sensitive a company's operating income is to sales changes. A higher DOL signifies a greater amplification effect:

High DOL: Companies with high fixed costs relative to variable costs see significant profit increases with small sales gains, but also experience dramatic profit drops with small sales decreases.
Low DOL: Companies with a high proportion of variable costs see less pronounced impact on profits from sales changes. Profits may grow slower but are also less volatile during downturns.
The Risk-Reward Spectrum:

Operational leverage is a double-edged sword. It can magnify profits during upswings, but also magnify losses during downturns.

Here's how risk relates to DOL:

Industry: Manufacturing with high equipment costs often has high DOL and inherent risk.
Growth Strategies: Rapid growth strategies involving debt can lead to a higher fixed cost structure and higher DOL, increasing risk.
Risk Management: Effective cost management, diversified revenue streams, and a cash flow buffer can mitigate risks associated with high DOL.
Revenue Type: High recurring revenue allows for a higher DOL as income is predictable. However, a high DOL with mostly one-time revenue is risky, especially with high financial leverage.

Evaluating Operational Leverage:

Cost Structure: Analyze the fixed vs. variable cost breakdown and the specific risks and benefits for the company.
Financial Statements: Analyze trends in revenue, cost of goods sold, operating expenses, and income on the P&L.
Balance Sheet: Review the composition of assets and liabilities, especially large fixed assets like machinery, which indicate potentially high fixed costs + capital expenditures.
Growth/Focus: Consider the company's scalability and future plans, as they will influence the optimal amount of operational leverage. 

By understanding operational leverage, companies can make informed decisions about pricing, production strategies, and risk management to optimize long-term profitability.

We dive into operational leverage more in this blog! 

A well-functioning accounting system provides the foundation for smart business decisions, optimized profits, and achieving financial goals. Let's break down what we evaluate and where we frequently see issues with small business accounting. 

Accounting is the meticulous process of recording, classifying, analyzing, and interpreting financial transactions. This meticulousness ensures reliable data for analysis.

Here's what good accounting looks like:

Accurate Transaction Recording: Every financial exchange, from vendor payments to customer receipts, needs clear details like date, amount, and vendor information.
Vendor Management: Maintaining good records of vendor terms, including payment deadlines and discounts, is crucial. Streamlined recordkeeping simplifies these processes.
Open Communication: Regularly share financial reports and discuss any concerns with your CPA, CFO, and finance team to ensure everyone's on the same page.

In order to achieve an efficient accounting process, many small businesses (including our clients) leverage modern accounting software like Gusto (payroll) and Ramp (corporate cards & bill pay), which significantly enhances accuracy, accountability, and automation. Here's specifically why we like to use accounting software:

Reduced Errors: Software automates repetitive tasks like data entry, minimizing human error and ensuring consistent financial data.
Increased Accountability: Corporate card solutions provide real-time spending visibility, allowing for better expense tracking and control.
Streamlined Workflows: Accounting software automates tasks like generating invoices, sending payment reminders, and reconciling accounts, freeing up your team for analysis.

A robust bookkeeping system goes beyond recording transactions. It empowers you to gain valuable insights for better financial health:

Improved Profitability: Identify areas to reduce costs or optimize pricing strategies to maximize profit margins.
Increased Cash Flow: By accurately tracking income and expenses, you can forecast cash flow and identify opportunities to improve financial liquidity.
Reduced Debt: Understanding your debt structure allows you to develop effective debt repayment plans.

Many businesses make these bookkeeping errors:

Unorganized Chart of Accounts: A disorganized chart of accounts makes it difficult to categorize transactions accurately.
Unreconciled Accounts: Regularly reconciling accounts ensures your records match your bank statements and identifies any discrepancies.
Lack of Internal Controls: Missing internal controls, like Standard Operating Procedures (SOPs) for handling cash and payroll, can lead to fraud or errors.
Outdated Technology: Relying on spreadsheets like Excel or Numbers for accounting can be inefficient and error-prone. Consider proper accounting software.
Delinquent Taxes: Proper record-keeping ensures taxes are paid on time to avoid penalties.

By prioritizing good bookkeeping practices and avoiding these common pitfalls, you'll gain the financial insights needed to make informed decisions, achieve your financial goals, and focus on what matters most – running your business.

Check out this blog for more information!