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.

Previously, we introduced readers to the third and final of the three major financial statements, the statement of cash flows, and produced the above-referenced example for our fictitious ABC Corporation.  Now it is time to do some financial analysis to see what the statement of cash flows has to tell us about the all-important cash position of a business.

At the conclusion of our previous post we mentioned that one of the entries on the statement of cash flows may very well be the most important figure on any of the financial statements.  So without further ado, let’s reveal what that figure is and why it is so important.  The object of our scrutiny is: net cash provided by operating activities. 

While you might thank that net income (i.e. profits) would be more important as it is the famous “bottom line” number from the income statement—and a favorite of the press when discussing a company’s financial results—savvy investors­, and business owners, prefer to focus on net cash provided by operating activities.

Net income can be subject to distortions—either intentional or unintentional—through tactics like not properly recognizing bad loans or misrepresenting the value of assets.  Because it is much harder to misstate profits and working capital, it always pays to look at net cash provided by operating activities, which reflects the effects of changes in working capital on a firm’s net income.  There are many examples of companies that have reported positive net income even when they are on the brink of declaring bankruptcy; in almost all of these cases though, net cash from operating activities began to deteriorate much earlier, providing an early clue that the firm was in trouble.

In the case of ABC Corp. we can see that while it had a positive net income of $23,000, its operating activities provided a negative $2,000 of cash flow.  This should cause us some concern as we continue to work our through the rest of the statement.

At the bottom of the next section, we see that ABC’s investing activities also resulted in a negative cash flow, in this case the figure is $6,500.  And in the last section we finally see some positive cash flow, to the tune of $3,500, as a result of ABC’s financing activities. The end result of all of this is that ABC saw its cash balance decline by $5,000 during the course of the year.

So what are we to make of all of this?  ABC’s operating activities drained it of $2,500 in cash yet it spent $8,500 on new fixed assets (a long-term investment), and it covered part of these costs by increasing its debt load (the $3,500 in additional notes payable).

The situation at ABC is clearly not sustainable and this is reflected in the fact that its cash balance at the end of year declined by 42% ($5,000/$12,000).  If ABC keeps on this same path for too much longer, it will eventually run out of cash.  In order to remedy the situation, ABC needs to take a hard look at refining its core operating activities, in addition to determining whether it has the right mix of assets to support its business, and whether or not its debt load is sustainable.  And of course, if you start to see your company’s cash position weakening, it is time to think about all of these things before the situation gets too dire.

So that concludes our series on the major financial statements that most firms produce, and that most lenders and investors want to see.  We once again remind readers that this series is intended as an introduction to financial statements and a beginning look at their analysis.  We hope that you are now better armed to analyze and make decisions about your firms’ financial matters, and encourage you to read further on these topics in a financial management textbook.

In our previous post we presented readers with the income statement of the fictitious ABC Corporation duplicated above.  In that entry we gave a brief explanation of each of the items on the income statement that may be helpful to review before proceeding further into this post, which is aimed at teaching you to analyze the income statement for information about the financial situation of a business.

Let’s start our income statement analysis by calculating a very important financial ratio, gross profit margin (also known as gross margin).  The math here is about as easy as it gets, gross profit margin is equal to gross profit divided by total revenue.  In ABC’s case we come up with a gross profit margin of 0.60 or 60% ($90,000/$150,000).  Gross profit margin can be thought of as a measure of efficiency, it tells us how much money is left over from sales after accounting for the cost of the goods sold.  While average profit margins vary greatly from industry to industry, as a general rule a higher gross profit margin indicates a more efficient company within its field.

The next figure we want to calculate is operating income or operating profit, as it is sometimes referred to.  Once again, the math is simple: operating income is equal to gross profit minus operating expenses ($90,000 – $5,000 – $45,000 = $40,000 in our example).  Operating income puts a dollar figure on the amount of money that a business is generating from its core activities and is closely watched by lenders and investors as a gauge of a firm’s ability to repay loans or pay dividends to investors.  If a business is experiencing growth in its operating revenues, then it will have more money available for expansion, debt repayment, or any other management initiatives.  The converse is also true of course, so if your business’s operating income has been steadily declining this should give some cause for concern.

Now let’s go ahead and calculate ABC’s operating margin, which is equal to operating income divided by total revenue ($40,000/$150,00) or 26.67%.  Operating margin tells us how much a company keeps from each dollar of sales, before it has to pay interest and taxes.  As with profit margins averages will vary among different industries, but the higher the figure, the better.  Looking at your company’s operating margins over time, by comparing different years’ income statements, can be an effective tool to measure how effective your firm is at keeping what it earns in sales revenue.  If your revenues are increasing but your margins are shrinking, it may be time to assess whether those additional revenues are worth the money it costs to acquire them.

So hopefully now you have an idea of what the income statement can tell you about your business and how to calculate some simple, yet important, ratios that will also be of interest to lenders and investors. As with our discussion of balance sheets, this series on the income statement is not meant to have been an exhaustive analysis.  We have left out a discussion of some of the more complex items that can appear on the income statements of large corporations, such as amortization and depreciation, although we may cover these in future posts. In any event you should now have the tools to understand a good deal about your own company’s income statement, and if you wish to read further, we’d once again recommend an introductory undergraduate or MBA-level financial management textbook.