The idea that “Cash is King!” is casually accepted as gospel by most small business owners.
And it’s true, the ability to bring in money consistently is essential to the success of your business—that’s a no-brainer.
But many aren’t aware of the vital differences between cash and revenue.
The difference between cash and revenue
Revenue is created any time you make a sale, but often this only means an invoice was created. It doesn’t count as cash until you actually see the money in your bank account, and this means you have to focus on collecting those dolla dolla bills (y’all!).
All too often, businesses work to increase their sales without regard to their actual cash position… and this can spell disaster for a small business owner.
In fact, many business analysts point to poor cash management as the number one reason that businesses go bankrupt.
If your business’s cash management could use some attention, don’t despair! Analyzing a few simple financial ratios can make a world of difference.
Whoah! Did your eyes just glaze over at the site of “financial ratios.” Don’t worry, we’re going to make this really simple.
First, let’s get some financial terms out of the way:
A Cash Sale is a sale that is settled immediately. The payment can be made by a card or other forms like actual cash, check or eCheck. The defining characteristic is the timing of the payment being made—at the time the sale is created.
A Credit Sale is a sale that is settled on a future date. Similarly, payment can be made in cash and be considered a credit sale. The defining characteristic is the timing of the payment being in the future, after services are rendered.
Accounts Receivable is the accounting term for all of the outstanding invoices owed to the company, at a specified moment in time. This will appear on your Balance Sheet under the Assets category.
Revenue is money that flows into your company. You can find this number at the top of your Income Statement, which is what causes revenue to also be called “Topline.”
Cash doesn’t necessarily refer to literal dollar bills, but instead refers to your business’s bank account balance. Your business’s liquidity is most often dictated by your cash on hand. This amount appears on your company’s Balance Sheet.
COGS, or Cost of Goods Sold, is the expense your company incurs that directly relates to the production of your product or service. Not all expenses are included in the group, since not all business expenses directly relate to a transaction. For example, if you own a lemonade stand, your COGS would include sugar, lemons, water, and labor. You would not include items like rent, insurance, etc.
Financial Ratio #1: Days Sales Outstanding, or DSO
Learning your DSO, or how many days it takes you to collect on your credit sales can streamline your accounts receivable process and boost your profitability, by adding predictability into your business.
To calculate your DSO, you’ll need (1) to determine a period of time, (2) your starting Accounts Receivable balance, (3) your ending Accounts Receivable balance, and (4) your total credit sales over the time period. If you use a bookkeeper for your business, this is information they can easily provide for you. If not, you can find it yourself by looking at your Balance Sheet and Income Statement.
How to Calculate Days Sales Outstanding, or DSO
Let’s take an example. Suppose you own a business that has $25,000 in Accounts Receivable (A/R) on September 1st, 2017. Then on October 1st, 2017, that amount was $20,000. Additionally, let’s assume you sell $45,000 on credit over that time period.
To get your DSO, first find your Average A/R for the time period. The average between $25,000 and $20,000 is $22,500, so this is your Average A/R.
The next number you’ll need is your Total Credit Sales, which was given as $45,000.
Lastly, determine the number of days in the period. September has 30 days in it, so we’ll use 30 for your Number of Days.
So, this tells us that it takes this business 15 days (on average, for this time period) to collect on a credit sale, which is pretty great for most industries.
Generally, a DSO under 45 is considered low, but this really depends on the business and the industry. Do a little research in your particular industry to see what is accepted as a “normal” DSO for you.
Great! So now you know your DSO… if you have a healthy DSO, congratulations! Keep monitoring it on a semi-regular basis to make sure that your business remains in good financial health.
If your DSO could use some improvement, however, don’t despair. A few changes in your collection processes could make a world of difference:
- Whenever possible, collect payment upfront: Many of your customers won’t resist paying upfront. All you have to do is ask!
- Offer multiple payment options to your customers: Most customers want to pay you for your services, but you have to make it convenient for them! Make sure you accept credit cards as well as eChecks.
- Make payments as automated as possible: If your customers have to rely on speaking with someone in your business to pay an invoice, you’re limiting their options and wasting time. Get set up for recurring online payments so that your business can collect invoices automatically.
Financial Ration #2: Gross Profit Margin
Another critical financial ratio worth giving attention to is your Gross Profit Margin. This ratio tells you what percent of your sales are profit, before accounting for your operating costs. That sounds a bit overwhelming, so let’s break it down into bite-sized pieces.
How to Calculate Gross Profit Margin
On an Income Statement, we start with Revenue. From that, subtract all of your COGS. The difference between these two numbers is called Gross Profit. Next we subtract all of your Operating Expenses (these are all of your expenses that are not included in your COGS). This difference is called your Operating Profit. Lastly, subtract your Taxes and Interest. The final difference is called your Net Profit.
Calculating your Gross Margin is pretty straightforward. Simply divide your Gross Profit by your Total Revenue. If your Income Statement doesn’t already show your Gross Profit, you will need to solve for it first (but a professional bookkeeping service will generally break it out for you already).
For example, let’s suppose you had Total Sales of $40,000 last month and your COGS for the same period is $15,000. To calculate your Gross Profit Margin, first solve for your Gross Profit:
Now, you can use this to calculate your Gross Profit Margin:
Now for the big question: what does this mean? This number tells you what percent of sales are left after subtracting the costs that produce your product or service. This can be of huge value to you when determining your competitiveness in your industry. If it’s your strategy to have a low cost compared to your competition, your gross profit margin will also be lower. On the other hand, if your strategy is to provide an exceptional product or service at a premium price point, your gross profit margin should be higher than your competition.
Another high value exercise would be to compare your Gross Profit Margin over time. For example, if your GPM for 2016 was 62.5%, but in 2015 it was 66%, this tells you that it is becoming more expensive for your company to provide your product/service, relative to your sales.
If you want to increase your gross profit margin, there are a few things you can focus on…
How to Increase Gross Profit Margin
- Increase your prices. Although some of your customers may go elsewhere, you’ll earn more in gross profit from those that stay loyal to you. You’ll have to balance the fear of losing customers with the dangers of a low gross profit margin when determining the perfect price.
- Reduce your COGS. Perhaps you can continue to provide a similar product/service while reducing the costs that directly relate to that sale. Many suppliers will reduce their price for you if you order in bulk, for example.
- Analyze your Sales Mix. Many businesses have multiple revenue streams (more than one product or service that they offer). Check the Gross Profit Margin for each of your revenue streams, and take action to sell more of the items with higher Gross Profit Margins. This will raise the margin of your overall company.
- Introduce new Revenue Streams. Perhaps there are new products or services that you can offer your customers. If these new revenue streams have gross profit margins that are higher than your current margin, adding them to the mix will increase your overall gross profit margin.
Keep an eye out for the next financial ratio, and comment below with the ratios you’d like to see covered!
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