Good question, right?
There is a good answer, and it’s probably not what you think.
You may have already guessed, “Well, I’m pretty sure it’s not the amount of money in the bank at any one time.”
And you’d be 110% correct.
Just because money goes out to pay for a necessary expense doesn’t mean your value decreases, if for no other reason.
Here’s an exciting, or discouraging (depending on your outlook) piece of news for you.
Ready?
There are dozens of ways to measure the performance of your business.
Dozens.
Do YOU need them all? Probably not.
I’m damn sure of the high probability that, if you’re reading this, you’re not using enough of them though.
Maybe not any at all.
That makes me sad.
That reminds me of that stupid joke in the movie “Caddyshack” when Judge Smails asks Ty how he measures himself against other golfers, and he says, “By height.”
In other words, it makes no sense at all.
If you run your business on the concept that if you have money in your business checking account and you can’t think of a reason not to spend it you go ahead…
…you might as well just lay your hand on a workbench and hit it with a hammer.
Equally dumb.
So, let’s start with the basics, shall we?
There are 3 major categories in the world of accounting, for every single business, since about the 15th century or so (the era of the invention of double-entry accounting).
Even if you just make beaded earrings and sell them on consignment.
Assets = what you own. This includes King Cash.
Liabilities = what you owe. Credit cards and loan payments are the most common.
Equity = In the simplest terms, what you have invested.
Equity is a function of math, without exception. Equity equals assets minus liabilities.
If you know what a balance sheet is, you have seen these three main categories, listed in that order.
Assets = Liabilities + Equity. This is called the accounting equation.
Take a look now. They’re equal, right?
So, there’s an argument to be made that equity equals value.
Well, kinda, mostly, but there are some nuances.
The biggest one I want to help you with today is the fact that because a balance sheet is a snapshot in time, just like a photograph, net income is a component of equity.
If you think about it, that just makes sense, right?
You close your net income for the year to your equity, but on every day other than December 31st your current net income is a crucial part of the company picture.
What is net income? In really basic terms, it’s your income minus your “outgo.”
That technical term is really just costs of goods sold plus expenses.
So, follow me here, that means that the profit and loss statement upon whose bottom line the net income lives is a subset and integral part of the balance sheet.
Let me bring this all home for you, and give you some explanation for why I’m going off on this pedagogical tangent.
You need to be looking at your profit and loss statement and your balance sheet every month.
Bare minimum.
I tend to look at them in that order, in fact, which is why I explained the role of revenue and expenses in equity first.
I know what’s coming next, from at least a few of you…
“I don’t have a profit and loss statement or a balance sheet. Am I supposed to? How do I find that stuff?”
If you want financial reports, you must first have a set of books, and it’s very much in your best interest to keep them with some type of software.
Software will create these financial reports for you, assuming your entries are “clean.”
Decades ago, when Windows was new and cool it seemed the big go-to was to hop down to the computer store and buy QuickBooks in a box, which means uploading a DVD-ROM to your hard drive, but nowadays online, or cloud-based accounting systems are much more prevalent.
If you’re new in business, and you’re making any kind of money with it at all, without some kind of books set up you’re in a world of hurt.
For one thing, you need good numbers to do your taxes.
But, of equal importance is knowing where you are.
Growing? Hitting a plateau? In need of new capital? Falling flat on your face?
How in the hell do you know if you don’t track?
Good news for the very small and new business that really doesn’t feel like they can afford an accountant or a subscription to QuickBooks Online yet: there’s a free option called Wave that will give you enough to track a very simple business.
It has its limitations, but it works well enough if you have very basic expense categories.
I would take a look at these lines at least once a month:
✅Gross revenue
✅Total costs of goods sold
✅Total expenses
✅Net income
✅Total current assets
✅Total current liabilities
✅Owner’s draws
✅Total equity
There are some accounting ratios that they beat me to death with in college, which all (for the most part) boil down to dividing one line of your financial statement into another one.
I think a good one to know for anybody is called the “quick ratio,” which is a current ratio except with the current assets being the highly liquid ones. Think “cash you can get with a mouse click.”
It measures your short-term ability to pay current debt (think credit cards), and you just divide that number into your highly liquid (cash) assets total.
You don’t even really need a calculator to see that, though – you can see the two numbers on your balance sheet.
Is this helpful? What I want for you to take away from this is that if you don’t track your revenues and expenses, and have no idea how much of your business bank account you can have when you need some of it, you are NOT in control of your business.
Let me wrap up then, with what I consider value. It can be two things.
One is the total equity amount. This concept is similar to the equity of a homeowner: you have a house, you have paid down principal to a certain point plus enjoyed the appreciation of the property (in most cases, I would think) for several years.
Let’s say you bought for $300,000, you are listing for $400,000, and if you get it closed in two months you can pay off a loan balance of $180,000.
You have $220,000 in equity currently. Big assumption.
Because it’s not yours until it’s closed.
Same thing with your biz.
Your true and genuine value of your business is what somebody else would pay you for it in an arm’s-length transaction.
I had some company write to me about purchasing my current business a year ago. After talking on the phone with him for a while he admitted that they generally offer about 1.5 times the amount that the business made in the previous verifiable year.
Oh HELL no! Are you kidding?
Even with that figure being wildly higher than my balance sheet equity at that time, I realized in a sudden white-hot epiphany that the value is really considerably higher, at least in my own mind.
So, my conclusion is this: the value of your business is, to be totally fair, the rock-bottom amount you would allow someone to pay you for it.
You gotta think, though – it was your baby, every bit as much as the human infant kind. What would it take for you to part with it, really?
Even more importantly, what if you could continue to grow and scale it as you have been up until the sale? Wouldn’t that be like a golden goose autopsy?
We all know how that guy felt afterward.
That’s my take on that for this week.
Thanks so much for joining me on this business journey today.
See you soon!