Financial Statements: Understanding Your Greatest Management Tool

I once read a snippet in a local newspaper that said 95% of business owners don’t look at their financial statements because they don’t understand them. This fact absolutely floored me! I believe this partially explains the high failure rate for start-up businesses. I learned early on that your financial statements can be your greatest management tool if you understand how to interpret them and use them effectively to determine your business’ financial performance, identify problem areas and project for the future. The two most common statements are the balance sheet and the income statement, which some refer to as a profit and loss statement.

The Balance Sheet

Think of the balance sheet as a financial snapshot of your business at a particular point in time. By using a specific reporting date, it provides an image of the financial health of a business and is divided into three categories: assets, liabilities and equity or capital. The reason this statement is referred to as a balance sheet is because it is based on a simple equation: assets minus liabilities equals equity or stated otherwise, assets equal liabilities plus capital.

Assets are any tangible or intangible items that have value for a business. They include everything from cash in a checking account to fixed assets such as furniture, equipment, vehicles, etc. used to operate a business, as well as other items such as good will, security deposits paid to others and loans and accounts receivable.

Liabilities are accounts that identify any outside party to whom a business owes money or is obligated to provide goods or services to. They include accounts payable, payroll or sales taxes owed, funds collected in advance of providing goods or services, loans from other parties, etc.

Capital or equity includes money contributed to a business to finance its operations at the outset as well as over time plus retained earnings or minus losses accumulated historically minus any draws or distributions taken from profits or equity by ownership over the course of time.

The balance sheet is an essential statement not only for business owners, but also for potential lenders who must determine the risk involved in lending money to a business. In the past, a standard rule of thumb has been that a business appears financially healthy if its assets exceed its liabilities by a ratio of at least two-to-one. However, with the current lending climate being what it is, businesses may be held to an even more stringent standard.
Another important metric for judging the well-being of a business’ financial health is the quick ratio. It is a comparison of accounts receivable to accounts payable to project the cash flow of a business in the short-term future. Obviously, if the ratio is one-to-one or payables exceed receivables, this is an ominous sign for cash flow down the road.

In a product-based business, a third essential measure of health is the turnover rate, how long it takes for a business to sell all of its current inventory before needing to replace it. The shorter the time period is, the better. A longer time period indicates that too much capital is tied up in inventory that is not being sold quickly enough.

The Income Statement

The income statement is a report of the profitability of a business over a period of time. The reporting period can be a month, a calendar quarter, a year, etc. The three most common sections of an income statement include income, cost of sales and expenses. The income section includes product sales and services provided.

Cost of sales are expenses that are directly related to the production of income. For a product-based business this includes the cost of items that are resold to customers, the cost of subcontractors necessary to produce income as well as other direct costs such as freight, duties paid, etc. Separately stating cost of sales from general operating expenses is important because subtracting these costs from income provides an essential figure, the gross profit margin of a business. Monitoring the gross profit and gross profit percentage is important because inflation is a natural and inevitable fact of our economy. Rising costs of sales that are not addressed by raising a business’ prices or fees to keep pace will erode the gross profit over time, narrowing net profits or even creating operating losses.

Operating expenses are the general costs of running a business and include such common items as rent, utilities, insurance, office expense, repairs and maintenance, etc.

The so-called “bottom line” on an income statement is the net profit of the business. It is the result of subtracting cost of sales and operating expenses from gross income. A positive number is the indication of an operating profit, while a negative number shows a loss.

When evaluating a business’ profitability, it is useful to include a column that shows percentages on an income statement. Each industry or profession has certain benchmark values that serve as a guide to creating profitability. The numerator used to form the percentage for each line-item on an income statement is its dollar amount and the denominator is the total income amount. For example, if payroll expense is $100,000.00 and total income is $500,000.00, the percentage appearing on the payroll expense line is 20%.

For existing businesses, a comparative income statement that compares the current year’s performance to that of the previous year is very helpful for identifying trends. Is the business growing compared to its past performance, maintaining its same levels as in the past or losing ground? An income statement that compares current performance to the past AND includes percentages as well can be most helpful for analysis purposes.