As a small business owner, you’ve almost certainly heard the phrase, “your financial statements say a lot about your organization.” But the truth is, many leaders feel lost when looking at their financials. It’s important for you to understand what your financial statements are telling you, because they can provide information about your business that you may not be able to intuit otherwise. Let’s go over the basics together.
Balance Sheet
The balance sheet reports the value of your assets, liabilities, and equity at a specific point in time. Assets are typically split into two categories: current and long-term. Current assets are those that will turn over in a year or less, like cash, receivables, and inventory. Long-term assets will stick with the company for at least a year, like property, equipment, and investments. Similarly, liabilities are split up between current and long-term. Current liabilities are items like accounts payable, accrued expenses, and the current portion of your long-term debts. Long-term liabilities are notes payable or mortgages that are due in the more distant future.
The last portion of the balance sheet is the equity section. Equity puts a number to how much value you have built up into your business. It may take the shape of stock equity (if you are a corporation) or of partnership equity (if you are a partnership). Your assets netted with the sum of your liabilities and equity should be zero.
Income Statement
While the balance sheet reports values at a specific point in time, the income statement (or profit and loss statement) shows activity over a period of time. For instance, a monthly income statement would show the sum of revenues and expenses that occurred during that particular month. Typically, income statements first report revenues, then expenses, and then show the difference as “net income.”
Something that many small business owners are surprised to learn is that their income statement is not a reflection of cash in and cash out. While income statements do often show cash activity, some items on the income statement will not be related to cash at all. Depreciation, for example, is a non-cash expense that will show up on the income statement. Additionally, businesses who operate on the accrual basis of accounting will have to “accrue” profit or expense items before cash has exchanged hands. To see your true cash activity, you should look to your statement of cash flows.
Statement of Cash Flows
The cash flow statement shows where you spent your cash over a period of time. Typically, these statements are organized in the following manner:
- Operating activities: This section shows your daily operational activities that require cash, like daily cash deposits, interest payments, and vendor payments.
- Investing activities: Your cash activities related to long-term business investments are reported here, like purchases of property or sales of securities.
- Financing activities: Lastly, you will report your cash outlays required for financing, such as dividends paid.
This statement can be useful to businesses whose growth requires them to keep a close eye on cash. It shows you first how you’re able to generate cash, and then how you use that cash.
What Should You Be Looking For?
Once you know what each statement is telling you, you need to learn how to interpret the information. The insight can help you make better financial decisions. Here are just a few things you can do to get started:
- Look at your accounts receivable balance over time. Are you collecting money timely? If your accounts receivable balance is growing each month, ask yourself why. You may need to establish new policies to ensure you’re collecting on those bills sooner.
- Review your cash flow statement. Is your money going where you think it’s going?
As an owner, you have your hand in all parts of the business, and you generally have a good feel for how well you’re doing. If you have less money on hand than expected, look into the cause. Start at the statement of cash flows to see where your money is going each month, and investigate anything that looks off. - Calculate financial ratios. Are you as efficient as you thought?
There are a number of financial ratios that can provide insight into your performance. Take inventory turnover, for instance. The inventory turnover ratio is calculated as [cost of goods sold] divided by [average inventory for the period]. It reveals just how quickly you sell your inventory. If you calculate this ratio for each of your products separately, you can pinpoint the best sellers and focus your energy there. Other financial statement ratios that can be of help are gross margin, return on equity, and earnings per share. - Compare your income statement to prior years. What outliers do you see?
Look at what’s different this year compared to last year. Is there an expense that’s much higher than last year? Is there a good reason for that to have happened? Are your sales segments performing in line with last year? You can also compare your financial ratios year-over-year to see when something seems to change.
It will take some practice to effectively interpret your financials, so be patient with yourself. Learn one new thing each month. The bottom line is that your financial statements are only as useful as you make them. Don’t pass up the opportunity to use these reports to your advantage. If you have any questions, don’t hesitate to contact a LaPorte Accounting Services professional.