I have reviewed thousands of small-business financial statements in my career. More than eight in ten are pretty much worthless. The financials produced are generally riddled with errors and unusable for decision-making purposes. While the financials may look reasonable, when you dig in, the data is inaccurate. Garbage in, garbage out.
When you build a home, you begin with the foundation. If the foundation is wobbly, the rest of the structure is in a constant state of repair or crisis. When the foundation is solid, the rest of the structure is solid. Day to day, your attention is not required to maintain your foundation, yet you depend on it to be a source of constant support.
When it comes to business, accurate, timely financials are your financial foundation. Without this solid foundation in place, you and your company fall into financial chaos— under performing and missing opportunities. With your financial foundation in place, it is a constant source of support and guidance.
There are three basic financial statements that need to be prepared monthly. Each one is important, and each tells a different story. Here is a quick rundown of the three statements, their components, and what you can learn from them.
The Balance Sheet
Think of the balance sheet as a photo of your business. A financial picture taken at a specific moment in time. It presents the assets, liabilities, and equity of your company at a point in time. By tomorrow or next week, the photo will have changed. The basic equation that builds the balance sheet is:
Assets = Liabilities + Equity
Assets are things of value that your business owns. They include cash, accounts receivable, inventory, investments, land, buildings, equipment, prepaid expenses, and some intangible assets, such as goodwill and trademarks.
For small businesses, assets are generally reported at their cost. This means that some of your most valuable assets, such as the business’s reputation, great management team, and brand recognition are not reported as assets unless you purchased the business from someone else.
Liabilities are obligations the business owes to others. They include bank loans, trade accounts payable, unpaid and accrued payroll, credit card balances, taxes payable, and more.
The stockholders’ equity or owner’s equity is the difference between your assets and liabilities. Think of equity as the portion of the assets you, as the owner, own outright. You increase equity in two ways. First, by contributing personal assets to the business. Second, by retaining income within the business for future growth.
If equity seems confusing, go back to the basic equation for the balance sheet: Assets = Liabilities + Equity. You can acquire assets two ways, by borrowing money or with your own equity. You can build equity two ways. Contributing personal assets to the business or keeping income that the business earns inside the business for future growth.
Use your balance sheet to learn:
• The financial strength of your business
• The ability of the business to meet its short-term obligations
• How leveraged the company is and how it therefore might respond in a recessionary period
• How strong the cash flow and working capital is, which can allow the business to respond quickly to opportunity
Think of your income statement as a movie that tells you what happened over a period of time in your business. It presents the revenue or sales, cost of goods or services sold, gross margin, overhead expenses, and profit or loss generated during a period—typically a month or year. While you may use the cash basis of accounting for tax purposes, for your internal use, the income statement should be prepared on the accrual basis of accounting. By using accrual, you are matching the revenue of the period with the related costs for that period.
Revenue is the cumulative amount earned from the sale of goods and services in the period.
Cost of goods or services sold is the cost of the goods or services that were sold for that period. For example, if you sold 1,000 units of product, your cost of goods sold would report the cost of that 1,000 units. Cost of goods or services sold varies in accordance with sales. In other words, as sales or revenue increase, the cost of goods or services sold increases proportionally.
Gross margin is the difference between sales and cost of goods or services sold. Gross margin, expressed as a percentage, is the most important number to manage and track on your income statement. When expressed as a percentage of revenue, it should be reasonably consistent from month to month. To determine your gross margin percentage, take your gross margin dollars and divide by your revenue in dollars.
Overhead expenses are the overall costs of running the business outside of cost of goods or services sold.
Overhead typically falls into five large buckets:
1. People and related costs, such as benefits, training, team outings, and payroll taxes
2. Business development, including all sales and marketing expenses, such as advertising, commissions, events, marketing support, etc.
3. Facility costs, including rent or building depreciation, insurance, repairs and maintenance, utilities, property taxes, and any other costs associated with your physical space
4. Technology costs, such as software licenses and technology support services
5. Other overhead costs, such as donations, interest, professional fees, bank charges, and postage
Overhead is relatively consistent in terms of dollars each month.
The next item on the income statement is tax expenses. Most small to midsize businesses are pass-through entities. As such, they pass their income through to their owners and do not pay income tax on their own. For these entities, there is no income tax expense. For C corporations, which are subject to tax, the income statement should reflect an estimate of the tax expense for the period.
Profit or loss generated during a period is the revenue that remains after the related cost of goods or services, overhead expenses, and tax expenses of the same period. Think of your net income as the return you receive for your investment in the business and your hard work.
Use your income statement to learn the following:
• How well your business performed for the period
• Your significant costs
• The consistency or inconsistency of your gross margin percentage
• Your net profit margin and your return on investment
Statement of Cash Flows
Think of your statement of cash flows as the report card on cash inflows and outflows for the period. As with an income statement, the statement of cash flows is for a particular period, typically a month or year. Net income and cash flow for a period are often different, and the statement of cash flows explains those differences.
For example, if your customers pay you in arrears, often thirty to ninety days depending on the terms, your revenue on the income statement reflects the amounts billed for the period. By contrast, your statement of cash flows reflects the collections on accounts receivable for the period. Another typical difference is loans payments. The principle payment on a loan is not an expense, so it does not reduce net income. It does consume cash, and your statement of cash flows identifies that use of cash.
Use your statement of cash flows to learn the following:
• If the business generated or consumed cash for the period
• Where cash was used for the period
• If your business is building or depleting cash and at what rate