Your Financial Statements Are Trying To Tell You Something
Updated: Jul 30, 2020
You know that health app on your phone or watch? The one constantly giving you updates on your health and fitness. Well that is basically what the financial statements are for your small business.
Financial Statements tell you a story. They tell you if your business is healthy or not. They also tell you if you are headed in the right direction or if it is time to change things up. The importance of financial statements cannot be overstated.
Maybe you don’t use your financial statements to manage your business (I think this is a mistake). Eventually though, they will come in handy as you will likely need them to complete any major business transaction. Obtaining a business loan or selling the business generally require current and historical financial statements to reach completion.
What are Financial Statements?
Financial statements are typically made up of three unique statements, the balance sheet, income statement, and cash flow statement. Each statement is like a chapter in a book. Combined you have the full story of the health of your business. That book should give you and any interested third-parties an accurate snapshot of the company’s financial health.
Let’s work our way through each of the statements, beginning with the balance sheet.
The balance sheet is a snapshot of the business’ financial position at a moment in time. The balance sheet is an accumulation of all transactions that have taken place since the business started. It has three distinct sections, assets, liabilities, and equity.
Assets - Anything owned by the company or anything owed to the company. Common examples of assets you will see on the balance sheet are cash, merchant (credit card processor) deposits in transit, accounts receivable, inventory, fixed assets (leasehold improvements, equipment, furniture), and intangible assets (goodwill, franchise fees).
Liabilities - Anything the company owes to another party. Common examples of liabilities are accounts payable, credit card payables, deferred revenue, and outstanding bank loans.
Equity - Assets minus Liabilities equals Equity. Ultimately equity is the net book value of your business. This typically is not a representation of the fair market value of your business however. Equity generally consists of retained earnings and various owner accounts like owner contributions (cash in) and owner distributions (cash out).
The income statement tells you how profitable your business has been over a period of time. Generally, you see an income statement based on a month, year, or year-to-date. Oftentimes, there will be a second column that shows the same historical period (e.g. last month, last year, or last year-to-date), so you can easily compare current results with historicals.
Income statement presentation can vary based on the type of business you own. Additionally, what is presented is very much based on how you initially structured your books. If your income statement is set up in a “standard” manner, you would expect to see the following (again this will vary based on your business and initial setup):
Revenue - How much you earned from selling your product or service.
Cost of Goods Sold (COGS) or Cost of Service (COS) - How much did it cost to build your product or provide your service.
Gross Profit - Revenue minus COGS or COS. This is a measure of how much you made on the sale of your products or services.
Operating Expenses - Generally necessary expenses you pay to run your business. Common examples include payroll, rent, utilities, marketing, insurance, and office supplies.
Net Operating Income (Net Profit) - This is a measure that tells you how profitable your business is after consideration of all expenses that directly impact operations. When attempting to sell your business, this line item is often the starting point for a potential buyer.
Non-Operating Expenses - All expenses that do not directly impact operations. When viewed from the outside these expenses are clearly not related to the operations of the business. Examples include interest expense, owner meals and entertainment, and non-work/service amounts paid to owners.
Net Income - This is a measure of total profitability of the business after considering all amounts earned and all amounts spent - the bottom line.
Cash Flow Statement
The cash flow statement tells you how much money flowed into the business and how much money flowed out of the business over a specific period of time. The cash flow statement is broken down into three sections, operating activities, investing activities and financing activities. The cash flow statement begins with Net Income from the Income Statement and then seeks to adjust all transactions to the cash basis of accounting. Let’s look at each section.
Operating Activities - Converts certain items on the income statement from the accrual basis of accounting to the cash basis of accounting. Let’s walk through an example. We will assume we are looking at the cash flow statement as of July 31, 2020.
Business had janitorial services performed on July 15th totaling $500. That invoice WAS NOT paid until August 15th. The accounting treatment for that transaction would be to increase Janitorial Expense and Accounts Payable for $500 on July 15th. The result is a REDUCTION in Net Income (again this is the starting point to the cash flow statement)
The cash flow statement must adjust this transaction to ensure that the cash effect is properly reflected. In the operating section of the cash flow statement, the transaction will yield an add back or positive $500 because as of July 31 cash had not changed hands
Investing Activities - This section reports purchases and sales of fixed assets (equipment, furniture, leasehold improvements, etc).
Financing Activities - This section reports new debt and repayments of existing debt.
The end result is a reconciliation between beginning cash and ending cash over a defined period of time. The three sections detailed above are an accumulation of the change in cash over that period of time.
Cash flow statements are an integral part of the financial statement reporting package for accrual accounting businesses as there are many adjustments that need to be made to see the true change in cash for a given period of time.
Cash basis accounting businesses have far fewer adjustments that need to be accounted for. The Income Statement effectively replaces the operating section of the cash flow statement. Adjustments do need to be made for investing and financing activities noted above.
Understanding your cash flow is vital to managing your business effectively and planning for the future, whether that is large purchases or simply meeting current obligations like payroll.
When read together, the balance sheet, income statement and cash flow statement provide a complete picture of the business’ financial health. The balance sheet tells you what you own, who owes you, and who you owe. The income statement tells you how much money you are making by selling your product or service. And finally the cash flow statement tells you where your cash is coming from and where it is going. Supplementing this financial information with critical non-financial indicators can take managing and operating your business to a whole new level. More on that in a future blog post.