There are enough numbers on the average income statement to make anyone’s head spin — especially if you are like the typical small business owner who isn't a trained accountant or financial controller.
The majority of small business owners will look straight at sales revenue. However, that number alone isn’t indicative of a business's financial health.
You also need to account for operating costs, profit margin, and free cash flow.
In this post, we're taking a closer look at the three most important financial metrics that all business owners should review on their financial statements.
Revenue is the total income a business generates from the sale of goods and services as well as other sources, such as interest, royalties, and fees.
Revenue is defined in terms of set time periods, like monthly, quarterly, or annually. For instance, if a service business billed their clients for $50,000 in October and earned $15,000 in royalties and interest, their monthly revenue would be $65,000.
Pro Tip: revenue is sometimes referred to as sales. However, sales refer to income generated only from goods and services, whereas revenue incorporates both sales and additional income sources like interest. Revenue is the total of all pure income reported by a company.
The main difference between profit and revenue is that profit is business income after expenses. In other words, profit is the total after deducting the necessary costs for your core operations, like cost of sales and direct costs, etc.
For instance, if a business earned $65,000 in monthly revenue but spent $25,000 to generate that revenue, their monthly profit is $40,000. Like revenue, profit is also measured in set time periods.
There are two main types of profit: gross profit or net profit:
Taxes and interest deducted from net profit include state and federal income and payroll taxes as well as interest owed on startup debt, such as a business loan. Unlike gross profit, net profit accounts for all business liabilities, making it the most accurate reflection of profitability.
Cash flow is the amount of money that moves in and out of a business at a given time. Like profit and revenue, cash flow is always measured in a set time interval, such as monthly or quarterly. This measurement allows founders to properly track their actual cash and cash equivalents on a regular basis.
Cash flow is characterized as positive, negative, or neutral:
One of the biggest mistakes we see, especially from first-time business owners, is confusing revenue, profit, and cash flow.
They usually over-prioritize revenue at the expense of the business.
In terms of a P&L statement, revenue is considered a company’s top line or the metric that’s listed first on the document. Revenue is the total amount of income generated by a business in a set period, whereas profit is the income that remains after all costs have been deducted. In other words, revenue is pure income, and profit is the actual income earned by the company.
This means that a small business can generate revenue and not turn a profit. For instance, if a small business earns $20,000 in monthly revenue but has to spend $25,000 in monthly inventory and payroll, the business will be $5,000 in the negative.
Turning a profit doesn’t mean you’ll have a nice cash balance in your bank account, and you can confidently run all of your core business operations and make payroll every two weeks.
Profit describes general business success in an average month or quarter, but it can’t explain if your startup has enough cash to survive long-term. Cash flow describes the health of a business’s daily finances and if your company can maintain typical operations. For instance, a business can have positive cash flow and no profit if the money comes from non-income sources, like a business loan. You can also have negative profits but still have free cash flow.
If you only track one metric in the business, then it should be free cash flow.
Tracking your cash flow takes into account all of the money moving in and out of a business. It also allows a founder to know how much cash is available in the bank at any given time. If a small business was forced to stall operations (like during a global pandemic), free cash flow would indicate how much money is available to fulfill short-term obligations.
That’s why cash flow forecasting, using software like PocketCFO, can be so effective. It can help with:
Cash flow forecasting enables a founder to not just be profitable but to operate a healthy business that’s sustainable in the long term. Unfortunately, forecasting via spreadsheets can be complicated, especially when also tracking revenue and profit. Cash flow forecasting software can take the guesswork out of business financials for optimal business health.
Ready to have peace of mind over your business’s finances? Sign up for a free trial of PocketCFO.