Once you have achieved a certain level of success as an entrepreneur you may find yourself weighing whether to put more money into your own business, or to invest in others businesses through the stock market.  While we are not here to offer specific investment advice, we would suggest considering the following factors when faced with this decision.

Begin by taking a look at your entire investment portfolio, including the value of your ownership stake in your business, to see if you are sufficiently diversified.  While there are no hard and fast rules about what an entrepreneur’s portfolio should look like, a well-diversified one usually includes investments in stocks/bonds, some  and enough cash to meet projected needs, in addition to the stake in the business.  If you feel that too much of your net worth is wrapped up in your company, then investing outside of it to realize the benefits of diversification (less risk, lower volatility) may make sense.

If you are sufficiently diversified but still weighing whether to invest inside or outside of your firm, then you’ll want to consider the rates of return that you can reasonably expect to receive from different investments.  For investments within your firm you’ll want to look at the internal rate of return (IRR) of various projects that you could take on.  IRR calculations can get pretty complex, so you’ll want to involve your CFO or other in-house expert, but in general terms you can think of a project’s IRR as the growth rate it is expected to generate.

For investments in the marketplace you’ll want to look at the historic returns of the different asset classes (stocks, bonds, cash, etc.) over a long period of time and see how those compare to the IRR of investing in your own firm.  If the gap between your IRR and external market returns is rather large, this can help you to invest your cash in the right direction.  Keep in mind that past market returns are no guarantee of future performance and that the actual rate of return you earn from investing in your own company may differ from your projected IRR.  Still, comparing your IRR with historical market returns can be a healthy and instructive exercise.

If you decide to invest in your own business, your options, of course, are not limited to taking on new projects.  If your firm is profitable but operating below capacity then you may want to increase your marketing budget.  In this case you should take a look at the marketing channels you are currently using and the return on investment (ROI) of each one.  ROI is a performance metric that can help you evaluate and compare the efficiency of different investments to help ensure that you are funneling your dollars to the strategies that generate the most profit.

Finally, you’ll want to consider the tax implications of the different investments that are available.  A 7% return in the stock market, versus a municipal bond with a 7% coupon, versus a project with a 7% IRR can result in vastly different after-tax returns, so consult your accountant or tax advisor for help in determining which investments make the most sense for you and your company from a State and Federal tax standpoint.

While diversification is a worthy goal, losing money in the stock market is disappointing and you gain nothing from the experience. While investing in your own company will always bring you some value, even if your investment doesn’t pay-off. Entrepreneurs are famous for learning how to succeed by failing first.

We recently concluded our Introduction to Financial Statements series that gave readers an overview of the three major financial statements: the balance sheet (Part I and Part II), the income statement (Part I and Part II), and the statement of cash flows (Part I and Part II). Throughout our discussion we used the statements to calculate some ratios, such as the current ratio and quick ratio in part two of the balance sheet post, that are useful in gauging the financial well being of a company.  Now let’s take a look at six more ratios that are easy to calculate and can offer more clues to the health of your business.  We’ll use the financial statements that we created for the fictitious ABC Corporation in our prior posts, so you may want to have those handy as we go through this lesson in ratio analysis.

The aforementioned quick and current ratios are the two most important liquidity ratios, as they give us information about a company’s liquidity position, which reflects its ability to pay off its debts in the near term.

The next category of ratios, the asset management ratios, tells us how well a business is managing its assets.  Let’s look at two of them.

Inventory Turnover Ratio = Total Revenue (also known as Net Sales) divided by Inventories.

In ABC’s case we have an inventory turnover ratio of $150,000/$10,000 = 15.  This means that each item that ABC stocks is sold and restocked, or turned over, 15 times a year.  The important thing to watch for here is how ABC’s turnover ratio compares with the average for firms in its industry (a firm selling fresh bread should obviously have a much higher turnover ratio than one selling custom-made electronics).  If your firm’s turnover ratio is much lower than the industry average, it is an indication that you are holding too much inventory, which can be a costly mistake.

Days Sales Outstanding (DSO) = Receivables divided by Average Sales Per Day.  (To calculate average sales per day we simply take total sales for the year and divide by 365.)

So ABC’s DSO is $13,000/($150,000/365) = 24.33 or roughly 24 days of sales outstanding.  The DSO tells us the amount of a time that a company must wait, on average, to receive its cash after making a sale.  In addition to comparing your DSO with an industry average, it is also helpful to see how it stacks up versus the payment terms that you have agreed to with your customers.  If ABC’s contracts call for payment within 30 days, then it is doing a good job of collecting the money it is owed during that window.  If, on the other hand, you find that your firm’s DSO is significantly higher than your payment terms, your business is being deprived of valuable cash and you may want to make more of an effort to collect your receivables on time.

Now, let’s take a look at two debt management ratios that can give us clues about a company’s ability to handle its debt load.

Debt Ratio = Total Liabilities divided by Total Assets and is expressed as a percentage.

ABC’s debt ratio is $38,000/$50,000 or 76% which means that its creditors have provided over three-quarters of its financing.  Once again, the industry average can serve as a good comparison point, but in general lenders prefer to see lower debt ratios as they indicate greater protection against losses.

Times Interest Earned (TIE) = EBIT divided by Interest Expense

ABC’s TIE ratio is $40,000/$5,000 = 8.  The TIE ratio tells us how many times over a firm’s annual interest expense is covered by its operating income.  As you would expect, a higher figure indicates a healthier company and one that is less likely to have trouble paying its debts.  If your firm’s TIE ratio declines steadily over time, or abruptly all at once, this should be cause for concern to both you and your lenders.

Finally, we want to examine two profitability ratios, which show us the combined effects of liquidity, asset management, and debt on a company’s bottom line.  As with the preceding ratios, comparing your firm’s profitability ratios to your peers will prove instructive.

Basic Earning Power (BEP) = EBIT/Total Assets (expressed as a percentage)

For ABC we have BEP of $40,000/$50,000 = 80%.  BEP shows us how well a firm is using its assets to generate earnings, so a higher percentage is preferable.  Keep an eye on how your firm’s BEP changes after you acquire new assets to see if those assets have increased or decreased your earning power.

Return on Common Equity (ROE) = Net Income divided by Common Equity

ROE is one of the most, if not the most, important of the financial ratios as it tells us how well investors in a business are doing on their investment.  ABC’s ROE comes in at $23,000/$12,000 = 192% (note that this is higher than anything you are likely to see in the real world, an ROE somewhere in the 10-30% range is more normal, but ABC has the good fortune to operate in the fictitious world).  A higher ROE indicates that a company is delivering its owners a higher return on their investment and that, of course, is what all investors want to see.

If you take the time to understand and track all of these ratios for your company, you will find that your financial statements offer a wealth of valuable and easy-to-calculate information that can help you run your business more smoothly.

Now that we have completed our guides to understanding your company’s balance sheet (Part I and Part II) and income statement (Part I and Part II), it is time to turn our attention to the third and final of the major financial statements, the statement of cash flows.  Like the income statement, the statement of cash flows gives us a picture of a company’s performance for a period of time, usually a calendar year or quarter.  But while the income statement is concerned with tracking net income, the statement of cash flows, as the name implies, is concerned with reporting changes in a firm’s cash position.  As we take a look at our sample statement of cash flows and decipher its entries, we will see that a company’s net income is very different from its cash position.

As we can note from the above sample of our fictitious ABC Corporation, the statement of cash flows is broken down into three categories—operating activities, investing activities, and financing activities—plus a summary section at the bottom.  If you are now familiar with the balance sheet and income statement from our previous posts, you should recognize most of the line items here because what the statement of cash flows does is pull information from those two statements in order to analyze their effects on ABC’s cash position.  As we go through the entries below, you may want to refer back to  ABC’s balance sheet and income statement to see where the numbers are coming from.

Net Income – Is the “bottom line” figure from the income statement.

Increases in Accounts Receivable, Inventories, Accounts Payable, and Accrued Payroll – These are all calculated by taking the difference between these figures on two successive balance sheets (e.g. 2010 and 2009 year-end).  For simplicity’s sake we only provided one year’s balance sheet for ABC Corp., but once your business has produced two or more balance sheets you would simply use the two most recent ones in order to make these calculations.  One important thing to note here is that an increase in a current asset decreases cash while an increase in a current liability increases cash.  For example, if your inventory (a current asset) increased, your cash would have to decrease by a like amount to pay for that inventory.

Cash Used to Acquire Fixed Assets – Calculated by taking the difference between the “Fixed Assets” entries on the two most recent balance sheets.

Sale of Short-Term Investments – Reflects short-term investments that have been converted to cash.

Increase in Notes Payable – Indicates the amount of additional short-term debt ABC has taken on.

Net Change in Cash – Equals the sum of the net cash provided by operating, investing, and financing activities.

Cash at Beginning of Year – Equals the Cash figure at the top of the most recent balance sheet.

Cash at End of Year – Cash at beginning of year minus the net change in cash.

Next, we will teach you how to analyze the statement of cash flows and show you why one item on it just might be the single most important figure to look at when analyzing any company.