Although you may have both an accountant and a bookkeeper on your payroll you, the business owner, still bear the ultimate responsibility for maintaining the financial health of your enterprise. Every business owner should be able to understand and make good use of business financial data. Each financial statement has a story to tell and you the business owner must be able to decode the language and comprehend the information that the numbers relay.
There are three financial documents that are generated monthly (and also compiled quarterly and annually): the Balance Sheet, the Cash Flow Statement and the Profit & Loss (or Income) Statement.
- The Balance Sheet resembles your checking account monthly statement. This document details business assets and liabilities, showing the monetary value of all the business owns and what it owes.
- The Cash Flow Statement is the business budget and shows what sales revenue will flow into the business and what expenses will flow out. This document helps you stay on top of how much money is available to cover expenses, like payroll and rent. Accounts payable (the bills) and accounts receivable (sales revenues) are listed on this statement. If you’ve ever managed a household budget, then you can master the Cash Flow Statement.
- The Profit & Loss (or Income) Statement is similar to the Cash Flow Statement. It contains many items that are also found on the IRS tax form Schedule C, Profit or Loss From a Business. Sales revenues and expenses are listed on this statement, including labor, taxes, inventory and the wholesale costs of products sold. Net Profit (also known as the bottom line) is the last line of this statement and this figure represents the ultimate story of business financial health.
One does not need a degree in accounting or an MBA in finance to identify which numbers on financial statements are most critical to your business and understand the story that each one tells. Keeping track of five or six key values, including values called ratios, will do wonders for your comfort level with financial analysis and in the process, guide your business decisions in many ways.
- Gross Profit in the P & L tells how much money remains after selling and product production costs, or the wholesale cost of products sold, have been tallied. Freelancers calculate this figure as time: how many hours were spent on your contract project, networking to create new business, developing a new workshop? Make a reasonable estimate of the wholesale cost of your labor. This figure gives insight into how much money/time it takes to make a sale. Can you work smarter and faster, or buy materials for products manufactured more cheaply? That’s how to increase gross profit.
- Net Profit, or the bottom line of the P & L, tells the ultimate story. Every line item that precedes it impacts it. If you want that number to be larger (and don’t we all?), look at all expenses to see what can be trimmed and also consider ways to generate new business through strategic partnerships, referral relationships, networking for client development, PR, etc.
- Gross sales revenues in the P & L may be tracked in two ways, looking back over what occurred in previous months or years (historical comparison) and going forward (projections, or forecasting) to what you reasonably expect and want to sell in a given period, guided by sales history and current demand for your product/service. Are you achieving, exceeding or failing your personal sales goals?
Finally, see your Balance Sheet and calculate these ratios, to expand your grasp of the financial data:
- Quick Ratio = Accounts Receivable + Cash – Inventory divided by Accounts Payable This figure indicates how much money is available to pay bills. A 2:1 ratio represents a business in good shape. However, a big receivables number can mask clients who take longer than 30 days to pay, thus signaling the owner to step up collection efforts.
- Current Ratio = Assets divided by Liabilities This figure measures resources available to pay debts over the next 12 months. A value > 1.0 shows a business in good shape, > 2.0 is a business in excellent shape.
- Working Capital = Current Assets – Current Liabilities This figure also demonstrates the ability to pay off short-term debts. Obviously, a positive number is what you want.
- Debt to Equity Ratio = Total Assets divided by Total Liabilities This figure indicates how much debt the business carries relative to its assets. A value <0.5 is excellent and values > 0.5 mean the business is carrying rather heavy debt and is considered highly leveraged.
Thanks for reading,