The 3 Steps to Financial Fluency
It’s daunting, isn’t it? Considering all that you must do in business, you also need to be a financial analyst. Understand income statements, budgets, forecasts, and planning (whatever that is!)
Well, I have good news. It all boils down to 3 steps. And when taken step by step, it is doable for everyone!
Step 1: Understand a few key relationships
Our human brains do not digest a wall of numbers (aka the usual Income Statement or Balance Sheet) meaningfully. We must use relationships to help our brains make sense and meaning of the numbers.
These relationships can be represented by ratios! And the good news is that less is more in this department. When we focus on a few key ratios, we are more likely to do so on a regular basis and have a better understanding of them.
The ratios we focus on with 60 Minute CFO are:
Current ratio
Debt-to-equity ratio
Gross profit margin
Operating profit margin
Net profit margin
Receivable days
Inventory days
Payable days
Return on equity
Revenue per administrative employee
Operating cash flow margin
Financing cash flow margin
Net cash flow margin
Once you understand these basics, you can identify and select the key ratios that are relevant to your business. Aim to stick to fewer than 20 ratios to avoid overwhelm. Not sure where to start? 60 Minute CFO can guide you in this process.
Step 2: Understand the relationship between the Income Statement and Balance Sheet
In this step, we delve into the crucial connection between cash and profits. Surprisingly, there is no direct relationship between the two. This often poses a challenge for business owners, especially those dealing with inventory. They may see substantial profits on the income statement but have limited cash on hand. The answers to this puzzle lie within the balance sheet, particularly in the inventory.
Elevating the importance of the balance sheet in your monthly reporting is beneficial, even if you aren't an inventory-based business. The balance sheet not only reflects your company's equity but also holds the key to understanding your cash flow. By examining the balance sheet regularly, you gain insights into the availability of cash and the overall financial health of your business.
Additionally in this step, you will learn how to generate a statement of cash flows which is often missing from monthly reporting. This step truly unlocks the potential to never have a cash crisis surprise you again.
Step 3: Learn how to forecast your financials
Now comes my favorite part: forecasting. Forecasting financials has the potential to become your favorite piece too, especially if you're a business leader. As leaders, we are inherently future-focused, always striving to be prepared. Remember the saying, "Fail to plan, plan to fail"? When you incorporate planning and forecasting into your financial analysis, you become nearly future-proof.
The best part is that steps 1 and 2 lay the foundation for step 3. By understanding the key ratios and the relationship between the income statement and balance sheet, you are well-equipped to dive into financial forecasting. Start by creating a worst-case, best-case, and most likely version of your financial plan. This allows you to anticipate and react to various outcomes, whether they are positive or negative. By contemplating these scenarios in advance, you'll be better prepared to navigate any surprises that come your way.
So, embark on your financial fluency journey now, and if you've already started, keep going. Remember, it's a journey, not a destination. Continuously strive to improve your understanding of financial analysis, and reap the rewards as you make better-informed decisions for your business.