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

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Income State­ments

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

Taking a step back and accurately executing these three statements will save you time and money in the long run.

After all, “An hour of planning can save you ten hours of doing.” — Dale Carnegie.