Many privately-held business owners think putting together financial statements is busywork. You have a business to run, so can’t your accountant just whip up what you need and send it off wherever it needs to go? In theory, yes they could do that.
But the most forward looking business owners understand that doing the numbers isn’t just perfunctory. Your financial statements tell very specific stories about your business. Gold has value because of its beauty and rarity. Your business has value because of its profitability, cash flow and potential for future wealth.
The value of your company is communicated through its financial statements. And reading financials can be very frustrating if you don’t know what you’re looking at.
Why It’s Important
Understanding your company’s financial statements allows you to feel comfortable working with and asking questions of finance professionals and lenders. Being able to interpret your financials can also help operationally by identifying areas that may need change.
Every activity you undertake as a business owner is connected to finances. The more you know about finance, the more insights you have about your business. When you know the drivers of financial performance, you are able to drive the respective business activities in order to achieve greater success.
The Basics of Financials: Income Statement
A chief component of a company’s financial statements is an income statement, which measures income and expenses over period of time. This should be reviewed on a regular basis to tell you how well your business is going.
Income statements help privately-held business owners answer the following questions:
- Is my business generating a profit?
- Am I spending more than I’m earning?
- When am I spending the most, and when are my costs lowest?
- Am I paying too much to produce my product?
- Do I have money to invest back into the business?
Here are the fundamental terms you’ll need to know to understand your income statement:
- Revenue: What your business takes in
- Expenses: What your business spends
- COGS (Cost of Goods Sold): Taking into account the component parts of what it takes to make whatever you sell
- Gross profit: Total revenues less COGS
- Profit: Total revenues less total expenses
- EBITDA: Earnings before interest, depreciation, taxes and amortization
Gross profit is especially important as that’s what’s available to pay your operating expenses. EBITDA is typically only important when dealing with investors or lenders.
Analyzing these numbers can help you determine where your company could improve, including comparing them to industry averages. The better you know your financials, the more you can help tell their story to lenders, investors, accountants, clients, buyers and even the IRS if need be.
The Basics of Financials: Balance Sheet
While income statements show how well your business is doing over a period of time, a balance sheet is specific snapshot period of your financial strength. It uses the basic accounting equation of assets equals liabilities plus equity.
Assets are what you own, while liabilities are what you owe. Asset and liabilities are typically broken down between short-term (current) and long-term.
Equity is what you are worth from a cost perspective (not fair market value). Positive equity means you have assets that exceed your debts.
The Basics of Financials: Cash Flow Statement
The cash flow statement is often overlooked but it’s very important. Most small businesses fail due to poor cash flow management and the subsequent lack of capital. It’s important to understand your income statement and balance sheet first because the cash flow ties directly into those numbers.
A cash flow statement shows where you have spent your cash over a period of time and is broken down into three categories: operating, investing, and financing.
- Operating Activities: This is how much cash have you generated from making and selling your product. A positive balance indicates you are managing your business well. A negative balance indicates problems, including possible pricing issues or aging accounts receivable (i.e. customers not paying in a timely manner.)
- Investing Activities: This is how much cash have you invested in your business or made from investments (stock, bonds, etc.) A negative balance indicates you may be in growth mode and investing back into your business.
- Financing Activities: This is how much you received from debt or how much debt you have paid down. A positive balance could indicate you took out debt to either pay for expenses or to invest in your business, while a negative balance could indicate paying down debt.
What Financial Statements Don’t Reveal
While financial statements include a multitude of important financial information for business owners, they’re far from all-telling. Financial factors not covered include:
- Will your business continue to operate into the future as well or as poorly as in the past?
- Has fraudulent activity occurred?
- Can your business be compared to peers with only financial statements as a reference tool?
- The market value of your business assets
- Non-financial factors surrounding the business
- How do the actual numbers compare to budget?
Financial Statements and Ratios
Lenders review your financial statements when determining key ratios to quickly access your financial health.
So what does your lender want to see in terms of financial ratios? Ratio expectations differ by industry, size of business and other factors, but in general, here are the most common benchmarks:
- Current ratio: 1.5-to-1 or higher
- Quick ratio: 1-to-1 or higher
- Debt to equity ratio: 3-to-1 or higher
Here are other ratios to be aware of:
- Performance ratios (gross profit margin, operating expense margin, net profit margin) should be consistent with your history and others in your industry.
- Accounts receivable turnover ratios should be consistent with your A/R terms.
- Inventory turnover ratios should be consistent with your history and others in your industry.
- Accounts payable turnover ratios should be consistent with your payment terms.
Remember: Ratio expectations aren’t hard and fast, and strengths in one can outweigh weaknesses in another. The better you understand your financial statements, the better you’ll be at presenting your accurate fiscal situation.