One of the most important things you can do as a business owner is to get comfortable with “the numbers”. If you can read a nutrition label in the supermarket or follow a footy guide, you can learn to read basic financial statements – so don’t let the numbers scare you.
This month we are going to review the three most important financial statements – the ones you should be reviewing on a regular basis.
Profit & Loss or Income Statement
Your Profit & Loss is your business report card. This report breaks down your revenues generated and expenses incurred to enable you to understand your profitability over a fixed period of time.
PROFIT & LOSS STATEMENT
For: Specific Period of Time
GROSS PROFIT –
The statement reports your revenues – all the income you have generated over the specified period. Then deducts your direct costs – all those costs that are directly related to income generating activity. If you are a retailer then your direct expenses will be the cost incurred for the goods you have sold. If you are a hair salon then direct expenses might be the cost of the colour used and the hairdresser’s time.
The difference between your revenues and your direct costs is your gross profit. From here the Profit & Loss deducts all those expenses not directly relate to sales. This will include items like rent, utilities, equipment & marketing.
The difference between your gross profit and your expenses is your operating profit. This lets you know the profit you have generated by operating your business over a specified period of time.
It is a good idea to review your Profit & Loss at the end of each month. Look at your profits over different periods of time. What profits did your business return this month? What profits have your returned so far this year? Look at your profitability now versus the same time last year and consider what has changed and why.
Investors will use your Profit & Loss Statements to assess the level of risk involved before extending credit. Obviously, the more profitable your business: the less risk for an investor.
Cash Flow Statement
Your Profit & Loss Statement will let you know if you made a profit over a specified period. What it doesn’t tell you is how much cash is actually coming in and out of your bank account.
The Cash Flow Statement reports the cash generated and used over a specified period of time. This report is critical. Never forget that it is entirely possible to find yourself insolvent, even while making a profit!
CASH FLOW STATEMENT
For: Specified Period of Time
CASH FLOW FROM OPERATIONS
CASH FLOW FROM INVESTING
CASH FLOW FROM FINANCING
NET CASH FLOW
To start, your Cash Flow Statement reports the cash flows as a result of operating activities. This looks at the same revenues and expenses as your Profit & Loss but converts everything to reflect cash only. So, for example, if you issued an invoice but it still hasn’t been paid, this will show up as Revenues on your Profit & Loss, but it will not be reflected on your Cash Flow Statement until the money hits the bank.
Next the Statement reports your cash flows from investing. This section looks at the inflows and outflows of cash resulting from the purchase of property, equipment, securities and other long term business investments.
Finally the Statement reports your cash flows from financing. Here the statement summarises the inflow and outflow of cash received as a result of business loans, lines of credit or capital infusions.
The net cash flow is the sum of cash flows from operations, investing and financing. This lets you know whether your cash position has gone up or down over the period, and most importantly, it helps you to understand where your cash is going.
As with your Profit & Loss, it’s a good idea to review your Cash Flow Statement monthly. You will use this statement to help you to manage your day-to-day activities and make critical financial decisions, such as when to purchase inventory, or bring in additional capital to fund seasonal fluctuations.
The Balance Sheet is snapshot of your business health at a stated time. This is probably the first financial statement that a bank or potential investor will look at. It provides a good indicator of your company’s stability and liquidity, and enables you (and investors) to assess your ability to fund your own growth.
On: Specific Date
Current Assets Current Liabilities
Property & Equipment Long Term Liabilities
Intangible Assets TOTAL LIABILITIES
In basic terms your balance sheet is divided into three sections.
“Assets” summarises what your business actually has. This will include everything that you own, as well as things you control such as a financed vehicle.
“Liabilities” summarises what you owe. This includes your loans, credit cards and debtors.
“Equity” summarises what is left over for the business owners.
The information in a balance sheet helps to assess the net value of your business, how effectively you are managing your assets and whether you are over-extended in your borrowings.
The set up of a balance sheet can vary wildly, so it’s a good idea to review your balance sheet with your accountant in the first instance.
If we can be of assistance in helping you, or others in your business, to better understand “the numbers” do not hesitate to get in touch. It is remarkable how empowering it is to be able to read financial statements and react to the information they provide.