How Small Businesses Manage Their Finances
Consider this scenario: The owner of a bakery (let’s call her Michelle) added a catering service about a year ago. Orders are coming in left and right, so she wants to buy more inventory and a top-of-the-line industrial mixer to keep up with demand. Shouldn’t be a problem with all the revenue coming in, right?
But when Michelle checks her business bank account, she’s shocked: The purchases would eat up nearly all of her cash. The bakery is profitable, so how could this be?
The answer gets at the heart of why proactive financial management is so crucial for small businesses.
Michelle invoiced catering orders, but didn’t realize clients were taking 30, 45, even 60 days to pay. So the money she’d recorded as profit wasn’t actually in her bank account yet. Plus, she had bills to pay that were nearly due.
Confusing profits and cash is one of the most common mistakes small businesses make when managing their finances. Half of all businesses that fail are actually profitable—the problem is they run out of cash and can’t afford to pay their bills.
Thankfully, proactive financial management can help your small business avoid these pitfalls. For those running a business but without a business degree or financial background, this small business financial management guide covers the essentials for laying a solid foundation to making profitable and cash-smart decisions.
Financial Management Basics
When someone’s talking about business finances, they’re thinking of information that can be found in one of three documents: a profit & loss statement (also called an income statement), a balance sheet, and a cash flow statement.
You don’t need to be an expert on financial statements, but it’s important to know what each one says about your business. Plus, it’s crucial to manage your finances in a way that other people can understand. If you’re looking for funding from a bank or investor, they’ll expect your financial information to fit in these formats.
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Profit & Loss Statement
The P&L is probably the most straightforward, and commonly used, financial statement. It simply tells you if your company is profitable or not. To do this, it starts with a summary of your revenue, then subtracts your costs and expenses. The result is your business’s net profit or net loss.
Balance Sheet
The balance sheet is a bit trickier to understand, at least initially. It tracks the value of everything your business owns (assets), what it owes (liabilities), and how much wealth it has generated (equity). It’s basically a snapshot of the financial health of your business.
Cash Flow Statement
The cash flow statement is where the difference between profit and cash really stands out. It tracks the ways cash moves in and out of your business over time, and helps a business owner determine if they’re managing their cash effectively or burning through their cash too quickly. A cash flow statement covers three things: how much money you earn or spend on day-to-day activities (cash flow from operations), money spent or made from buying or selling assets (cash flow from investment), and money raised from or repaid to an outside source like a bank (cash flow from financing).
All three statements contain information to make better financial decisions. But we’ll focus on the P&L and the cash flow statement, since they’re more relevant to ongoing financial management.
Tracking revenue and expenses
The P&L is the easiest statement to immediately draw information from. It simply tells you if your company is profitable. Are you generating more revenue from sales than you’re paying in expenses?
But using it to manage your business better requires looking deeper into the details of your profit and loss statement. It’s time to get specific.
Revenue
What are all of the ways your business makes money? For Michelle, it could be:
- Baked goods
- Sandwiches
- Beverages
- Custom cake orders
- Wholesale (selling to local grocery stores and restaurants)
- Catering
Breaking these out is important for a few reasons. You need to know how much revenue each source of money is going to generate, as well as its direct costs (or costs of goods sold). Don’t go overboard and make a separate revenue stream for every kind of pastry or drink, though. If you’re a small business, between three and 10 categories is the sweet spot.
For a product-based business like a bakery, each revenue stream has different direct costs. A catering order will require a lot more ingredients and equipment to prepare than a single batch of pastries, so although it generates more revenue, it’s also more expensive to get that revenue.
When you subtract direct cost from revenue in the P&L, you get your gross profit. For instance, if Michelle made $200,000 in revenue one year, and paid $150,000 in direct costs, she would have $50,000 in gross profits, or a 25% gross profit margin.
Knowing your margins will be key when you start forecasting your business’s future revenues, and comparing those forecasts to your actual results. We’ll get into details about forecasting momentarily.
Expenses
Next, compile all your business’s operating expenses. You may be thinking, “Didn’t I just do that with direct costs?” But this is another common mistake that even experienced business owners can get wrong. Direct costs should only include the costs it takes to make the sale (think about the ingredients Michelle needs to buy to fulfill catering orders).
Operating expenses cover costs that affect the business as a whole, not just for a single product. For Michelle, operating expenses might include:
- Rent
- Utilities
- Payroll
- Insurance
- Marketing
Once you’ve compiled all of this information, you simply subtract all of your expenses from your gross profit, and you get your net profit.
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Using Your P&L to Make Better Decisions
Once you understand what’s driving your revenues and costs, you can start creating financial forecasts of your future sales and expenses. And this is where you really start reaping the benefits of proactive financial management.
These forecasts — or projections of business performance — are educated guesses about what’s going to happen in your business in the future, typically over one to three years.
Existing businesses use their past data as a starting point for their forecasts. Then they make educated guesses about what’s going to happen, based on their future plans and assumptions.
New businesses also need to make educated guesses about the future, based on what they know about their potential customers and other market research that they’ve done. For new businesses without a history of revenue and expenses, it can help to build a few different scenarios to see how things look if sales go well, or if sales don’t ramp up quite as fast as hoped for.
Then, they run their business. And over time, the real power of forecasting becomes clear.
Let’s go back to the bakery example to show why forecasting is so powerful. When Michelle expanded into catering a year ago, she created sales and expense forecasts to project how a new revenue stream would impact her business.
Maybe she projected a 10 percent increase in revenue compared to the previous year, and a 5 percent increase in expenses. But after a year of catering, she updates her profit and loss statement and sees things didn’t go quite as she had planned: Sales are up 8 percent, but expenses are up 7 percent.
What changed? What didn’t go as expected? Maybe it turns out that inflation made her extra ingredients more expensive than she had planned. With this information, Michelle can come up with a response, like raising her prices or switching to a lower-cost supplier.
And she may not have even known this was a problem if she hadn’t taken the time to create a financial plan, and compare her actual numbers to that plan. That plan versus actual comparison is how you review progress, track results and adjust your strategy depending on performance. Reviewing your plan and actuals monthly puts your business in a much better position to change course more quickly than if the review only happened once or twice per year.
Understanding Cash Flows
I stressed at the start of this article that cash is not the same thing as profits. I also mentioned that half of businesses that fail are profitable when they go under.
Cash flow explains why.
Your profit is the calculation of revenues minus costs and expenses. But think about how businesses collect money. Is every order paid for in full, with cash, at the time of sale? That’s unlikely. Many businesses make a sale, and send the customer an invoice with payment terms like “net 30” or “net 60,” meaning the customer has 30 or 60 days to pay.
So even though the business owner has recorded a sale and recorded it as revenue on their profit and loss statement, they don’t actually have the money in their bank account.
Think about Michelle’s catering customers. Some of those orders may generate as much as $1,000 in revenue. But only a few of her customers have paid her upfront and in full. She’s been invoicing with 30-day payment terms, but many customers are taking closer to 60 days to pay.
This is why Michelle’s business bank account was lower than expected when she wanted to buy that new industrial mixer. Her cash outflows (money leaving the business) rose sharply as she purchased more groceries to fulfill catering orders. But her cash inflows (money coming into the business) were coming in at different times than she had planned for.
Meanwhile, she’s had to pay for fixed costs that she can’t put off, like rent and payroll. So even though she’s profitable on paper, she’s facing a cash crunch.
Forecasting Cash Flows
Just like sales and expense forecasts help project your future profitability, cash flow forecasting projects your future cash position.
But since cash and profits are different, cash flow forecasts need to be compiled separately.
Since businesses generate and use cash in different ways, a cash flow statement — the basis for cash flow forecasting — is broken out into three parts, which we’ll detail with the bakery example:
- Cash flow from operations: Cash Michelle generates from daily sales or spends on day-to-day business activities.
- Cash flow from investment: Cash Michelle spends buying assets like equipment, or generates if she decides to sell an asset.
- Cash flow from financing: Cash from a bank loan Michelle obtains, or monthly payments she needs to make on the loan.
Let’s say that Michelle also created a cash flow forecast when she began offering catering services. She had assumed monthly cash from operations would rise at a relatively steady rate throughout the year as she took on more catering orders.
But in reality, the timing of her cash inflows was staggered, based on when clients paid their invoices. Perhaps when she hit her cash crunch, she had just sent out paychecks, paid rent and made a payment on a loan. But, her past three catering gigs hadn’t paid their bills yet. So the money she assumed was in her bank account for the industrial mixer wasn’t actually there yet.
This is why cash flow is really about money management. And it’s why comparing your forecast to your actual performance is such a valuable exercise. Reviewing Michelle’s plan against her actuals reveals that she needs her customers to pay her faster.
So she can use cash flow forecasts to plan out different scenarios for her business:
- How would her cash position change if she got everyone to pay within 30 days?
- What if she required a 25 percent deposit for all catering orders?
- What if she offered a 10 percent discount for customers who paid upfront?
The process of regularly reviewing your cash position and comparing forecasts to actual results gives small businesses greater control over their finances. And it’s what drives proactive, not reactive, financial management.
Further Reading
Putting it All Together
Now that you know how to create forecasts and compare your forecasts to your actual results, you can start putting them to practice.
Start by setting up a monthly review process. This is your dedicated time to compare your forecasts—sales, expenses, and cash flow—to your actual results. It’s where you answer questions like:
- Were sales higher than expected?
- Did a new marketing campaign pay off?
- Were supply costs surprisingly high?
Looking at where your results differed from your plan helps you ask the right questions. What decisions do you need to make based on this new information? What changes might you need to make in your business to stay on track or seize a new opportunity?
As you gather this information, you’ll need to revise your forecasts. While you review your performance monthly, adjusting your forecast each month may not give you enough time to see if changes are part of a real trend or just a temporary blip. But waiting a full year is far too long, leaving you reacting to outdated information. For most small businesses, revising forecasts quarterly gives them enough data to identify clear trends and make meaningful adjustments to their strategy.
The key is to create a rhythm of forecasting, reviewing, and adjusting. Once you’ve done that, you’ll be able to develop a deeper understanding of what’s driving growth and what’s holding you back. You can make strategic decisions with confidence, because you have a strong grasp of their potential financial impact. This level of financial command not only makes you a better, more effective manager of your own business, but it also puts you in a much stronger position to secure a loan or investment.
Additional Tips for Effective Small Business Financial Management
As you build your financial management routine, keep these essential best practices in mind:
Keep meticulous books. Your forecasts are only as good as the data they’re built on. Use an accounting system, record transactions promptly, categorize them correctly, and reconcile your accounts every month to ensure your numbers are always accurate.
Build an emergency fund. Every business faces unexpected expenses or a sudden drop in sales. Having three to six months of operating expenses saved in an accessible account can be the difference between weathering a storm and closing up shop.
Account for all expenses. It’s easy to overlook costs that don’t occur every month. Be sure to factor in expenses like quarterly taxes, loan interest, and—most importantly—your own salary.
Don’t chase perfection. There is no such thing as a perfect forecast. You will never predict the future with 100% accuracy. The goal isn’t to be perfect; it’s to do the best you can with the data and assumptions you have, learn from the results, and make better-informed decisions going forward.
Elon Glucklich
Elon is a marketing specialist at Palo Alto Software who works with small business owners, consultants and advisors. He's also a freelance business journalist with over a decade of reporting experience. He has Master of Business Administration from the University of Oregon.
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