I have always been surprised by how many business owners don’t use their financial statements to manage their business. But over the years, I have come to understand why. It’s because they don’t really understand those statements.
One of the first things I tell business owners when teaching them about financial statements is that looking at just one financial statement can be misleading. You need to look at several to start sizing up what is really going on in your business.
You need to make sure your financial information is correct and timely. If your financial information is faulty, then you have a tendency to make faulty decisions.
If you get great financial information but it is six months after the fact, you lost the opportunity to correct a problem quickly or take advantage of an opportunity.
If you are new to the small business game and know absolutely nothing about reading financial statements, then you need to start with the basics.
I believe every business owner really needs to understand their income statement (sometimes referred to as a profit-and-loss statement), balance sheet and cash-flow statement. The way you go about that is by understanding what each statement measures and what the terms mean.
Income statement: The income statement lets business owners know what their company’s sales and expenses are for a given period of time. By keeping track of your sales and expenses, you can determine your profit or loss during any given period.
At the least, you need to get a monthly income statement. With today’s automated accounting software, you can look at your income daily, weekly, monthly, quarterly, etc. You can also compare any period of time with another period of time, such as comparing the performance of different months or different years.
As a business owner caught up in the day-to-day activities, it is easy to lose sight of how you are really doing. The income statement will help you look at sales trends, changes in cost of doing business and whether you are really generating income.
One factor that can change the “view” on your income statement is your accounting method. The accounting method dictates when sales and expenses are reflected on your income statement.
In simple terms, the cash method of accounting is where you count sales as income when you receive payment and expenses are reflected when you pay them.
With the accrual method of accounting, you count income when generated whether you have received payment; expenses are accounted for when you incur them, not when you pay them.
The accrual method really gives you a more accurate picture of how the business is doing because it matches income with expenses. It is important to note that if you deal with inventory, you must use the accrual method to account for it.
Balance sheet: The balance sheet lets the business owners know what assets they have, what they owe on those assets and how much is “theirs.”
A balance sheet always reflects a given point in time. It’s as if someone took a picture of the company that gives an accounting of the assets and who owns what. Also, the assets are always carried at cost.
If you bought a building for $100,000, it remains on your balance sheet for $100,000. It does not matter whether the asset goes up or down with regard to fair market value.
The loss of value through use is captured through depreciation. Depreciation can be calculated through a variety of methods. The amount of depreciation is dictated for tax purposes by the IRS.
I always recommend the business owner go over the balance sheet at the end of the year and make sure it is accurate. This is relatively simple to do but is often overlooked by owners.
You should always take a physical inventory at year end to make sure your inventory is accurate. Check your loan balance on the balance sheet and compare it to the loan balance according to the bank. These should be the same.
You can do analysis with the balance sheet to make sure you are managing your assets effectively.
Cash flow statement: The cash flow statement is really the bridge between your balance sheet and income statement. It shows you how you are using your cash. Cash comes from three areas: operations, financing and investing.
The cash flow statement can answer the age old question: “My income statement shows I made money, so where is it?”
Understanding the timing of cash flow in your business is critical to survival. The cash flow statement can show you where your cash is going and where you stand. Just remember. The financial statements are tools to help business owners manage their business. The more you understand your numbers, the more you can use them to help you succeed.
If you would like to learn more, The University of Georgia SBDC offers classes on this in the Maximum Money program. For details, visit our website or contact the Savannah SBDC office at 912-651-3200.
Lynn Vos is area director of the University of Georgia’s Small Business Development Center. Contact her at 912-651-3200.