Most small business owners get started to serve customers and to do something they find fulfilling. Not many find that fulfillment in reading financial statements. Yet these statements not only tell them how they’re doing but also suggest actions to promote future success. They are a critical leadership tool to aide in decision making.
There are three financial statements that every small business owner should understand. They’re the income statement, the cash flow statement and the balance sheet. Here are some keys to using each for business decision-making.
It’s also known as the profit and loss statement, or simply the P&L. It shows all the revenue and expense for a specific time period, be it a month, a quarter or a year.
It reads from top to bottom. Revenue is the top line, net profit is the bottom line, and different types of expenses and intermediate totals are in between, as follows:
- Revenue – Cost of Goods Sold (COGS) = Gross Profit.
- Gross Profit – Selling, General and Administrative Expenses (SG&A) = Operating Income.
- Operating Income – Interest = Pre-Tax Income.
- Pre-Tax Income – Taxes = After-Tax Income or Net Profit, aka the bottom line.
While everyone talks about the bottom line, the most fruitful places to make changes are near the top of the sheet.
- Increasing revenue improves numbers all down the line.
- Decreasing COGS means finding lower prices for inventory and reducing manufacturing costs.
- SG&A can be minimized by actions such as reducing utility and building expenses and targeting marketing campaigns effectively.
The last two expenses, interest and taxes, are areas where a business owner should consider consulting an expert for financial advice.
There are ratios that help a business owner gauge financial health.
- Gross Profit Margin = Gross Profit / Total Revenue
- Operating Profit Margin = Operating Income / Total Revenue
- Net Profit Margin = Net Income / Total Revenue
Ratios vary by industry, so it’s hard to make broad statements about desirable numbers. A professional accountant can help benchmark these against industry norms.
Cash Flow Statement
In accrual accounting, income and expenses on the income statement don’t correspond to cash flowing in and out. For example, when a sale is made, the customer owes money and the income statement recognizes revenue. However, a business can’t spend that money until the customer actually pays.
The Cash Flow Statement shows how much money was generated from (or used in) operations and how that cash was used for investments and where it came from in the form of financing. Even with a healthy income statement, a lack of cash means trouble in the future.
There are two ways to calculate cash flow: direct and indirect.
A direct Cash Flow Statement shows changes in cash from three categories:
- Operations: cash received for sales minus cash paid out for inventory, wages and other current expenses.
- Investing Activities: cash spent for major capital expenditures minus cash received for retiring them.
- Financing Activities: loaned money received minus interest on loans.
The direct method is straightforward but requires keeping track of every dollar received or spent.
The indirect method starts with net income from the income statement. It then subtracts any factor that added to net income but didn’t produce cash (e.g., an increase in accounts receivable). It adds anything that’s subtracted from net income but didn’t reduce cash (e.g. a decrease in accounts receivables).
If cash flow is low or varies greatly from period to period, the business should take action to improve it.
A balance sheet lists the company’s assets and liabilities.
Assets and liabilities are classified as current and non-current. Current includes cash, receivables, inventory, and debts due within a year. Non-current includes building, major equipment, and long-term loans.
A healthy company has more assets than liabilities.
Assets minus liabilities equals the third category on the balance sheet, retained earnings. This is the amount of money that has been earned and reinvested. Net profits for the income statement are added to retained earnings.
The current ratio is current assets divided by current liabilities. There’s also a quick ratio, which is like the current ratio but excludes inventory from the assets. If this is greater than one, the company can meet its short-term obligations.
The balance sheet also shows whether a company has enough overall assets to cover long-term debt.
Interpreting Financial Statements
A savvy business owner can learn much from the statements, but a knowledgeable partner such as Avisar Chartered Professional Accountants can really unlock the statements and show a business how to improve its financial position. Avisar specializes in taxes, statements, and consulting for small businesses, entrepreneurs and non-profits.
Read our Guide to Understanding Financial Statements for Business Owners for more on how to make the most of your financial statements.
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