Updated: Dec 16, 2020
"Accounting is the language of business." We've all heard, that right? The critical part that most business owners miss is how to speak the language. I always let my clients and prospects know that you don't have to know how to create the reports, but you do need to understand them. Reading financial statements isn't as easy as picking up the latest best seller and breezing through it. There are certain things that you need to know to better understand your business. Here are the top four things that I recommend business owners understand when looking at their financial statements.
1. Key Performance Data
As a business owner it is very tempting to buy the newest, brightest, and shiniest new thing on the market as an investment for your business. Especially in the world of social media, keeping up with the Jones is even more tempting. However, while you see your competition showing new purchases or bank account balances what they do not tell you is how much it cost them to generate that much revenue. As a matter of fact, they may not even know.
Your Key Performance Data or Indicators also known as KPIs are the pieces of data that let you know how well you're doing in reaching your goals. Let's look at a common one, return on investment also known as ROI. This is an equation that all business owners must understand to know how much money they are generating from investments that they are making.
Social media gurus may be enticing when telling you to pay for qualifying leads but what needs to be tracked is how much revenue do you make from each advertisement ran. How much revenue do you make or save as a result of investing in a training to teach you how to handle your finances or get leads? Without tracking these things businesses spend money unnecessarily and cannot put a cap on it and pivot. The key performance data comes from the financial statements. The Income Statement, Balance Sheet, and Cash Flow Statement.
2. Income Statement
This is the financial statement that most small business owners are somewhat familiar with in my experience. The income statement is also known as a profit loss statement and is what you turn in when it's time to do your taxes if you are a sole proprietor or SMLLC. The focus of this statement is revenue, expenses, losses, and gains. This statement lets you know how much you made during any period. More times than not business owners look at the balance in their bank account vs. pulling this report to see the whole picture. The income statement gives you the whole picture with how much you have actually made in your business because it is made up of not only your sales but also your expenses so you have a chance to see what your profit is at a glance.
This is why the IRS uses this form to figure your taxes. It tells how much money you made. It is also the form that lenders look at when applying for business capital or a home because it tells them how profitable your business is currently and how it did last year. Many times, the Schedule C (Business Profit Loss) from your 1040 can also be used if you are a sole proprietor or SMLLC.
This report when compared to other time periods also allows you to identify trends in your business. For example, is July a historically slow month for you? You would find this out by comparing data from income statements for this month which allows you to plan and pivot in your business so that you're prepared to bring in revenue in a different way for the month. Big swings in revenue or profit may require some deeper digging into your balance sheet.
3. Balance Sheet
The income statement ties directly into the balance sheet, in the owner's equity section and therefore lenders will often request this financial statement as well. The balance sheet is a picture of your business's financial health. As indicated by the title it tells how balanced your business is using the equation Assets (cash, properties, inventories) = Liabilities (outstanding debt) +Owner's Equity (owner's share of company). A lender is less likely to give a loan to a business that is top heavy with debt.
Your income statement may indicate that you are very profitable but your balance sheet may reveal that you have an unhealthy amount of liabilities, making it a high risk for investors or lenders to give you any more money. Let's say that you own a property for $1,000,000 and owe $90,000. Your owner's Equity is only $10,000. If you're business only nets $150,000 the lender would consider both your income statement as well as your property debt and equity before giving you a loan.
The debt to equity ratio is a direct connection to low or high interest rates for you. This KPI is one to be watching if you are looking to get capital soon or just in general because an interruption in cash flow can cause your business to fold instantly if you cannot pay your creditors.
4. Cash Flow Statement
Good companies pour back into their business by leaving income in the business and building owner's equity. The cash flow statement also known as statement of cash flows shows how well a company generates cash to pay its debt obligations and fund its operating expenses.
This can help determine whether a company has enough liquidity or cash to pay its expenses. A company can use a cash flow statement to predict future cash flow, which helps with matters of budgeting. The main components are cash from operating activities, investing activities, and financing activities. Knowing where your cash is coming from and what is eating up your cash is critical in making decisions on new ventures to pursue in your business.
It's important to note that the Cash Flow Statement is a separate report from the income statement and balance sheet because it does not include the amount of future incoming and outgoing cash that has been recorded on credit. Cash is not the same as net income, which on the income statement and balance sheet, includes cash sales and sales made on credit. Each report is distinctly different but works together to tell us the financial health of your business.
If you need help learning how to produce these statements with data from your business or you need more help understanding them and being able to track your KPI's you are likely a good candidate for the Small Business Accelerator . This program teaches you how to pay yourself, set aside money for taxes, and other expenses as well as how to create and read your financial statements. To see if you're a good candidate to work with me book your call today by clicking the hyperlink or visiting our site www.bowenstaxsolutions.com.
Timalyn S. Bowens EA is an Enrolled Agent, licensed through the Internal Revenue Service that works with businesses to increase profitability through strategic tax planning and the implementing of tax strategies through their budget. She is also the owner of Bowens Tax & Bookkeeping Solutions, a virtual accounting firm based out of Louisville, Ky.