Imagine this: you are a small business owner, and you notice a specific product you offer is moving off your shelves at an unprecedented pace. You want to get this inventory back in stock ASAP to meet the rising demand. You check in on your bank account to make sure you’ve got enough cash to cover this unexpected purchase. Shockingly, you only have a few hundred dollars in there. You think, “Wait -- when did this happen? I don’t remember draining out my bank account.”
Not only do you now have the stress of finding out where you money went and when you can bring that balance back up, but you’re missing the opportunity to take advantage of selling a hot product.
How could this have been prevented?
Mostly, it comes down to spotting the signs of trouble long before they can impact the long term health of your business. To do this, you need an objective viewpoint, a loyal team that isn’t afraid to tell you the truth, and knowledge of which warning signs are the first and best indicators of challenges around the corner.
Here’s how business owners can best recognize early indicators to avoid financial headaches down the line.
1. Stay objective about your business.
There’s a reason entrepreneurs are so often called irrational optimists. After all the blood, sweat and tears you’ve put into building your business, it can be almost impossible to remain objective about what is and isn’t working.
You believe in your product. You believe in your business model. You’re convinced that your business will succeed. Otherwise, why would you keep trying so hard?
However, that unending optimism also makes you susceptible to enormous blind spots in your business. That’s why it’s hugely important to regularly step back and take an objective look at how your business is doing financially. What are your weaknesses and trouble areas? Where are you most likely to hit financial challenges? Answering these questions requires viewing your business as it is, not just as you want it to be.
2. Cultivate open communication with senior managers.
Often your employees, especially top level operations personnel, can see the financial red flags long before you realize you’re in dangerous waters. That’s why it is so important to cultivate open lines of communication with your highest level managers. Invite feedback often. Ask employees to speak up about issues and warning signs that you may be missing.
3. Work with a great accountant.
Sometimes owners of very small businesses try to cut corners financially by handling their own accounting. While this may save you money in the short term, it is a recipe for disaster in the long term. Hiring an expert to keep watch for financial issues is a necessary expense for the health of your business.
Don’t make this mistake. Invest in a knowledgeable financial advisor who you can trust to notice and communicate any red flags that may be lurking in your business finances.
4. Review company financials regularly.
Once you’ve gathered your team of advisors and financial truth-tellers, you need to plan regular, objective reviews of your financial standing. A good rule of thumb is to review financial documents once per quarter. Look at your financial standing compared to previous quarters and for the same time frame year-to-year. Paying attention to how your sales, profit margins, and growth change in those time frames will tell you a lot about where your business is headed financially.
5. Watch for slower growth patterns.
This can be one of your best and earliest indicators, visible well in advance of hitting true financial challenges, if you know to look for it. Without paying close attention, most business owners would assume that any growth in sales is still a positive sign. However, knowing how that growth compares to past seasons really shows you whether you’re sustaining the same level of progress for your business.
Every quarter, compare your rate of sales growth to the previous quarter as well as year to year. If you notice your growth numbers slipping, look for ways to bring in new revenue long before that slow growth turns into stagnant sales.
6. Notice if profit margins slip.
No matter how much they love what they do, every entrepreneur is in business to make a profit. But if your overhead is growing and sales aren’t rising to meet those costs, your profit margins could quickly be shrinking.
Divide your net profit by your sales to determine your net profit margin. Compare that number to previous quarters and the same quarter in previous years. How does your net profit margin compare to what you’ve done in the past? If your margins are shrinking, it’s time to reduce overhead or find some new customers to make up the cost.
7. Watch for delays in accounts receivable.
Are customers taking too long to pay you, or not paying up at all? Low accounts receivables turnover can kill businesses by tying up cash in unpaid invoices.
To calculate your accounts receivable turnover, divide your annual sales revenue by your average accounts receivable. How does that number compare to last quarter or to the same time last year? If turnover is lower than in previous quarters, that may be an early sign of trouble ahead.
8. Don't ignore cash flow challenges.
Many financial experts will tell you that the number one reason businesses ultimately fail is not because of a business model flaw, but due to issues with cash flow. Even if your business is long-term profitable, if you don’t sustain enough cash on hand to cover your overhead, you can’t survive. If you find that you just barely have enough cash on hand at any one time to handle expenses next month, or even next week, that’s a big indicator of trouble on the horizon.
If reading through any of these early warning signs of financial trouble has given you that sinking feeling in your stomach, don’t panic. There’s a reason we call them “early” warning signs—and every business owner is likely to come across one or a few of these issues at some point. By staying objective about your business, communicating with your advisors, and spotting potential sore spots before they become huge issues, you still have the opportunity to right the financial ship well before you reach dangerous waters.