Having financial statements is important.
Think about the dashboard in your car. You have many gauges and lights that tell you different things going on in your car.
For instance, you have a gas light. If the gas light is on, it’s a warning that you need to fill up your gas tank. If you avoid this you may get stuck and you may not make it to your intended destination.
Or you have an oil light. If this is on and you don’t put oil in your engine, your engine could potentially seize you and you will have a major problem.
This is all good information to have. This information allows you to make good decisions for your vehicle, your primary need for transportation which is very important.
Financial statements are much like the gauges on the dashboard of your vehicle.
They give you information about the financial condition of your business.
We run into many entrepreneurs who don’t know how to use this important information, and that’s ok, they are entrepreneurs and should be casting vision and building stuff.
However, they should still have a high level of knowledge on how to use financial information to help them get closer to their goals.
In this article, you will learn about:
- The three standard financial statements
- 5 ways to understand your financial statements
- Top 3 Takeaways
Let’s dive in.
The three standard financial statements
Do you know the three standard financial statements that you should be using to assess the financial condition of your business?
If not, we got you.
- The Balance Sheet
- The Profit and Loss Statement
- The Statement of Cash Flows
Your balance sheet is a statement that will help you to understand the financial condition of the Company.
We all want to know how our business is doing, don’t we?
It shows all of your assets, liabilities, and equity in the business.
Your assets are things like cash, accounts receivable, and fixed assets. They are used to help your business produce future value.
Your liabilities are amounts you owe to third parties in the form of accounts payable. Liabilities can be good if used properly. They allow you to “borrow” as you typically have 30 days to pay the third party.
Long-term bank debt is another form of liability. This can be used for timing issues like making purchases up front that will produce value down the road and allow us to repay the debt.
Lastly, your equity is all of the capital contributed to the business as well as profits and losses accumulated.
Profit and Loss Statement
Your profit and loss statement will help you understand if the core product or service you are delivering is producing a profit.
It is divided into a few sections as follows.
First, you have your revenue and cogs. Your revenue is straightforward and represents your earnings for doing what you do. Your cogs, or cost of goods sold, is variable with your revenue. Meaning if your revenue goes up, it’s likely the costs to produce the revenue go up. The key here is the gross profit.
Next, you move into operating expenses. These are typically fixed expenses and things like rent, marketing, software, and salary expenses.
So if you take your revenue less your cogs less your operating expenses you will get to your profit number.
Cash Flow Statement
Ok, so your cash is driven by profitability. If your Company is producing a profit on its Profit and Loss Statement you are generating cash flow.
The cash flow statement shows all the sources and uses of cash.
As for sources, we simply mean where your cash is coming from. As for uses, we simply mean where your cash is going.
This is a great statement to help you get a handle on how much cash you burned through in a particular month and where it went.
General thoughts on financial statements
Ok, here are some general thoughts on financial statements in bullet form.
- These should be produced timely. Typically within 30 days of the end of the month.
- These need to be accurate. You need good financial statements to make good decisions.
- To get to accuracy you need the right person producing them. Make sure the team member has the right level of experience.
- If you are doing $1M or more in revenue, you should consider accrual accounting. It paints a more realistic picture of profitability.
- Reflect on these and seek to understand what they are telling you about the business.
In the next session, we will get into ways to understand the financial statements. It requires a pause at month end to really deep dive into them to pull out the “golden nuggets”.
We did write a detailed post on these financial statements here if you want to dive deeper.
5 Ways to Understand Your Financial Statements
We are pretty sure there are more than 5 ways to understand your financial statements.
However, we will cover 5 which should help you better understand how your business is performing.
Let’s take each financial statement one at a time and try to glean some wisdom out of them.
The balance sheet of your business will help you to understand the following:
- The degree of working capital in the business. Working capital is the business’s ability to meet short-term obligations with current assets. It is an indicator of the business’s ability to collect on receivables, manage inventory well, and leverage accounts payable terms.
For example, Amazon has $100 in current assets and $50 in current liabilities. The working capital for Amazon is $50 ($100-$50).
On the other hand, Facebook has $75 in current assets and $70 in current liabilities. The working capital for Facebook is $5 ($75-$70).
Amazon wins. The higher the working capital, the healthier the business as there is more of a cushion to meet the current needs of the business.
- The receivable turnover of the business will help you understand how quickly you are converting accounts receivable to cash. Cash is king, so the faster the better.
For example, Amazon has $500 in net sales and $100 in average receivables. The receivable turnover for Amazon is 5 ($500/$100).
On the other hand, Facebook has $500 in net sales and $50 in average receivables. The receivable turnover for Facebook is 10 ($500/$50).
Facebook wins. The higher the ratio, the healthier the business as cash is coming into the business quicker and the Company is managing collections better.
Profit and Loss
The profit and loss statement of your business will help you to understand the following:
- The Gross profit % of the business will help you understand how much profit you earned on the sale of your products or services.
For example, Amazon has $500 in net sales and $100 in Cogs. The gross profit for Amazon is 80%($500-$100=$400 then $400/$500=80%).
On the other hand, Facebook has $500 in net sales and $50 Cogs. The gross profit for Facebook is 90% ($500-$50=$450 then $450/$500=90%).
Facebook wins again. The higher the percentage, the more money is earned on the product sales. It states that for every $1 of revenue that Facebook earns, they get to keep $.90 for profit.
- The Net profit % of the business will help you understand how much profit you earned on everything. This includes your fixed expenses.
For example, Amazon has $500 in net sales,$100 in Cogs, and $20 in Op X. The net profit for Amazon is 76%($500-$100-$20=$380 then $380/$500=76%).
On the other hand, Facebook has $500 in net sales, $50 Cogs, and $5 in Op X. The net profit for Facebook is 89% ($500-$50-5=$445 then $445/$500=89%).
Facebook wins again. The higher the percentage, the more money is earned overall in the business. It states that for every $1 of revenue that Facebook earns, they get to keep $.89 for profit.
Cash Flow Statement
- The Cash burn rate of the business will help you understand the rate at which your business spends money and the number of months of cash you have available.
For example, Amazon has $100 in cash and spends $50 per month. The burn of 50 per month results in 2 months of runway. ($100/50).
On the other hand, Facebook has $200 in cash and spends $30 per month. The burn of 30 per month results in 6 months of runway. ($200/30).
Facebook wins again. The more months of cash flow the more the business can be supported longer.
Summary of understanding your financial statements
Based on utilizing the financial statements, we were able to understand things like liquidity, profitability, and even cash reserves.
These metrics, driven by the financial statements, help us to better understand how the business is performing.
The beauty of using the financials and these metrics is you can track and compare against yourself to see your improvement. You can even compare yourself against your competitors, industry averages, or your future goals.
No matter what, your financial statements are a great source of helping you understand the financial condition of your business.
And the better the financial condition, the higher the probability of your being able to have the resources to meet your goals and vision.
3 Key Takeaways
At New Economy, we want to help you gain control of your finances to make smart decisions. Part of that is understanding your finances and how to drive business performance.
Here are 3 key takeaways.
- Make sure you are getting accurate financial statements within a 30-day period after the month’s end. If you are not sure if your financial statements are accurate, reach out and we can provide you with some feedback.
- Take the time to reflect on your financial statements. Determine what they are telling you about the financial condition of your business. Continue to monitor your progress against the historical financial statements and benchmark against competitors.
- Do the work. Meaning, if your financial condition is not good or has deteriorated, determine what is driving that and fix it. Go into the business and spend the time getting to the root cause of the issue. The financial statements are just the indicator of something either being on or off track.
There you have it 🙂
New Economy Team Members are Experts in Accounting for Entrepreneurs
If identifying ways to decrease your taxes is not in your skill set or you want to gain control of your finances to make smart decisions to build and grow your business, New Economy is an excellent partner.
We’ll help you get your accounting and taxes done, and done right.
Schedule a time to meet with our Founder, Jeff, and discuss how we can add value to your situation.