Finance Basics for Small Organizations

An overview of some financial fundamentals that apply to all entrepreneurs and small business leaders. I will elaborate on many of these topics in future articles... but let’s get started, together, here.

Stay Organized

Staying on top of your business finances does not have to be stressful or time consuming. In just an hour or two each month, with a very basic spreadsheet (or even by hand for those who prefer), you can track your income and expenses. Monthly organization will save you a lot of time and spare you that overwhelmed feeling every year when it comes to filing your taxes. 

More importantly, the monthly process of accounting for your cash flows will give you insights into how your business is performing throughout the year. This information can help you adjust your sales strategy, reduce or change your spending, and better prepare you for the months ahead.

Simply keeping an eye on your bank balance isn’t quite enough. You want to know why it’s going up or down so that you can lean into what’s working and away from what’s not in real time, rather than waiting until the end of the year.

Keep It Simple

Especially if you are a new entrepreneur or don’t have a lot of experience with financial accounting, you can still get a lot of valuable information from some very simple calculations. For most small organizations a cash accounting method is simplest and best - just knowing how much cash you bring in each month and how much you spend puts you in the driver’s seat. Once you’re feeling confident with managing cash flow, you may want to start making some projections or doing some ratio analysis. But if you're new to the game, calculating your net income and basic margins (keep reading) is a great start.

Another essential tool, that sounds obvious but many overlook, is an annual budget. Like a personal one, a business budget is just an estimate of your expected expenses. It doesn’t have to be deeply detailed and even if you end up deviating from the plan, which is often the case, it will give you a clearer picture of how much you are spending, what you’re spending on, and insight into adjustments you can make to stay on firm financial footing. If you’re already more than a year into your business, then use your real numbers from the previous year and adjust for growth and anything else you expect to do differently going forward. If you haven’t hit a year yet, use your most recent month and multiply by twelve as a starting point. I like to include an educated guess for income at the top of my budgets so I can see the full picture. Just remember, be conservative here, and be honest with yourself - it’s just a tool for you to anticipate what’s coming.

Know Your Margins

Once you’ve got your income and expenses organized you have a basic income statement. The next step is to know your margins. A margin is an item or group of items from the income statement expressed as a proportion (a percentage) usually of your total income. There are two margins every entrepreneur should know: top expense margins and net income margin. 

First, you want to know the major costs of running your business and how much of your revenue you spend on those operations. For most small businesses 2-3 expense categories make up the bulk of expenses; items such as rent, payroll, equipment, and cost of goods. Take the amount of your highest expense and divide by your income for the same period to find its margin. Repeat the process for your second and third highest expenses. I like to consistently monitor any expenses higher than a 15% margin; you can calculate them all the way down to the smallest costs but knowing your top expenses and how much of your income they consume is essential for developing a sales strategy and budgeting for the coming months.

Next, you want to know your net income margin and it’s calculated in the same way. How much money did you make (income less expenses) and divide that amount by your total income for the same period. Net income margin is a great marker of how healthy and profitable your business is. Tracking this marker over time will provide insight into how efficiently you are operating. There is no “good”, or “bad” net income margin and average margins vary dramatically by industry. But this is another critical step in better understanding your business’ financial health.

Understand Cost Structure

Related, and equally as important, concepts to be familiar with are fixed and variable costs. They are just what they sound like: fixed costs are expenses that exist regardless of your income while variable costs are expenses that fluctuate because they are associated with your sales. For example, if you own a coffee shop, rent is a fixed cost; it’s the same each month regardless of how much coffee you sell, and you have the variable costs of coffee beans, ingredients, and cups, which are directly related to the amount you sell. Some expenses, like staffing costs in this example, can blur the line between fixed/variable, be considered either or both, and how you view them can depend on how the staff is structured. Knowing what your major costs are and whether they fluctuate in association with your income gives you more insight and helps inform better decision making.

Some industries are inherently high fixed-cost such as gyms, hotels, theatres, and auto shops while some are higher variable-cost by nature such as catering, apparel, contracting, and landscaping. Almost all businesses have a mix of fixed and variable costs, but it is important to know where yours falls on the spectrum because your cost structure will determine how you operate and scale.

Wrap Up

These basics: organization, simplification, margins, and cost structure are some low-effort, high-value ways to better understand your small business’s financial situation and strategy. Investing your time and energy into knowing the fundamentals of finance will go a long way in helping you build a successful and sustainable operation.