Have you hesitated about rolling up your sleeves and digging into the financial side of your company? Then read on.
This information will add years to the life your business—and make sense of your conversations with accountants and other trusted advisors.
Let’s Start at the Very Beginning
When accountants say “financial statements,” they mean three different reports that combine to give you a complete picture of how your business is doing:
• Income Statement
• Balance Sheet
• Statement of Cash Flows
You need all three for a well-balanced look, because each report answers different questions about how your business is doing.
Income Statement: “How Profitable Is My Business?”
Also called the profit and loss or P&L statement, that’s exactly what it tells you: if your business is making or losing money. The income statement always covers a specific period: such as last month, last quarter, or last year. It’s based on this equation:
Next is the cost of goods sold (COGS) section. In a service business, it’s often called the cost of sales. COGS is the expenses directly related to how your business makes money. You could not produce your product or offer your service without spending this.
Let’s say you sell granola. Your COGS includes the raw materials, such as oats and honey. It also covers packaging costs and what you pay the workers who make the granola. In a service business, your primary COGS is the wages you pay to employees who deliver the work you bill to customers.
When you subtract COGS from gross revenue, you have gross profit. When expressed as a percentage of gross revenue, this is your gross profit margin. It’s the money left over after all of the direct expenses (COGS) are paid.
The final section of your income statement is operating expenses (or indirect expenses). Examples include advertising, non-COGS employees, rent, telephones, insurance, utilities, and all the expenses that keep the business going.
If you subtract the operating expenses from the gross profit, you have net income. This is the famous “bottom line.” Net income is simply your revenue minus all direct and indirect expenses.
Balance Sheet: “How Wealthy Is My Business?”
You could call the balance sheet “your wealth statement.” To understand why, look at the equation behind it:
Assets are three things: your cash, your “stuff,” and the promises customers have made to pay you. Your stuff includes office furniture, computers, and any machines or equipment your business uses.
When you send customers an invoice, they have made a promise to pay you later. Accountants call the total of all the invoices that customers owe you your accounts receivable.
Liabilities are the promises you made to pay other people—such as vendors and lenders. Another word for this is debt.
If we add up all the assets (cash + stuff + promises held) and subtract your liabilities (promises you made to others) what you have left is your equity. Equity is how much of the business you own. In other words, equity is the wealth you have built up in your business. This is what you get to keep after all the dust settles between what customers owe you, and what you owe others.
Cash Flow Statement: “How Much Cash Money Is My Business Producing?”
This connects the income statement and the balance sheet. It also answers the common question, “If my income statement shows so much profit, how come there’s no cash in the bank?” Like the income statement, it covers a specific period: usually weeks, months, quarters or years.
It’s called cash flow because accountants see three different ways that cash can enter and leave your business:
• Cash from operations: If we collect a ton of money from our accounts receivable, that would be an example of cash flowing in from operations.
• Cash from financing: When we make principal payments to our lender, this is one way of cash flowing out from financing.
• Cash from investments: When the owner takes a draw or pays a dividend (not salary) from the business, that’s cash flowing out from investments.
This creates the equation behind the cash flow statement:
These reports answer a set of critical business performance questions:
• The income statement – Does my business model generate a profit?
• The balance sheet – What’s the return on my investment of time, money and entrepreneurial risk?
• The statement of cash flows – Is my business converting its profits into actual cash?
Taken together, they help you know where you are on the path to build a sustainable and profitable business.
That means making friends with your numbers helps you know what to look for in conversations with your business about your business. These statements aren’t there to judge you for what you did or didn’t do well. They’re only there to help you make better decisions—and what business leader doesn’t want to do that?