Financial Statements for Business: Why You Should Understand and Love Them
Let me ask you a few questions…
Do you get worried about whether or not your business will have enough cash to cover its upcoming bills?
Have you had to put money into your business because suddenly your checking account was negative and you had bills due?
Have you been working at your business for a while, and yet you can’t seem to make a profit?
Or maybe your accountant has given you your financial statements, which say that your business made a profit, but you are not sure where that profit actually went?
Are you thinking about taking on a loan or an investor to give your business extra money, but wonder what impact it will have on your business?
If you answered yes to any of the above questions, then it is likely that you don’t completely understand how to read and leverage your financial statements.
But don’t get embarrassed, the majority of small business owners don’t.
We didn’t when we first got started.
And guess what, we struggled for the first few years in business.
We were not taking a paycheck.
Even worse, on several occasions, we actually had to put our own money into the business.
We kept thinking… “didn’t we start a business to make money, not lose money?”
It caused stress.
It caused issues between Ariana and I.
Several times I felt inadequate as an entrepreneur.
And it seemed like we were further away, not closer, to our personal and financial goals.
But then something happened that turned it all around.
One of my mentors (a very smart entrepreneur indeed) started asking me some financial questions, such as:
- What is your Year to Date (YTD) Revenue?
- How does that compare with your YTD Targets?
- How does that compare to your YTD Revenue from last year at this time?
- How much cash are you projecting to bring in in the next 30-60-90 days?
- What bills and other financial obligations are due in the next 30-60-90 days?
- What is the Net Worth of your business?
But I didn’t know the answers. And I felt so embarrassed.
But you don’t have to feel embarrassed, simply read on (and download our free introductory guide to understanding your financial statements).
Thankfully, instead of letting me feel embarrassed, my mentor took some time to explain the basics of how to read them.
And you know what? It was one of the most amazing experiences of my business life!
Before that, I was so afraid of our financial statements.
I was embarrassed that I was an entrepreneur, yet didn’t even know how to read the numbers.
But after having someone explain and coach me on the topic, I suddenly felt energized and empowered again.
It was like I saw a whole other side of my business; one that had eluded me for years.
With seeing this other side, suddenly I could understand how everything was connected.
I could make decisions easier, rather than just guessing and hoping they worked out.
And best of all, our profits started increasing.
I swear, it was like magic.
You see, after you have been trying to get profitable for years, it is so frustrating to keep guessing at what will make you successful, then crossing your fingers and hoping your decisions were right.
You see part of your business, but there is this other half that is hidden from view.
It’s like you are trying to read a book, but half of the words are written in another language.
And once you translate them, you can suddenly read the entire book and it makes sense.
Think of your financial statements as that translator.
You see a part of your business, but by understanding your financial statements, it lets you see the entire picture.
So before I jump in and explain how to understand and use the 3 main financial statements, I’m going to just dive a little deeper into the problems that you can have when you don’t understand these.
If you want to skip this and go right to the financial statements, scroll down below.
5 Challenges Arising From Not Using Your Financial Statements
1. You Don’t Find Problems Until It Is Too Late
There are a lot of problems that may exist in your business. One of the best ways to find them is by reviewing your financial statements often.
Your expenses might be too high, your sales may have dipped unexpectedly or any number of other things could come up.
By reviewing your financials statements often, you can identify these issues early and address them.
Otherwise, if you are only reviewing them at the end of the year, the problem may have started in January, but you didn’t find out about it until the next January. This means it was occurring for an entire year before you identified it and can fix it.
This can be costly and is easily avoided.
2. You Don’t Know If You Have Enough Money Month to Month
If you have been around entrepreneurs for any amount of time, you have probably heard the phrase “cash is king”.
This is true, but not quite that simple.
See, you need not only the right amount of cash, but also the right amount of cash at the right time.
It doesn’t do you much good if you are going to receive $30,000 in 3 months but owe $10,000 this month and you don’t have the cash to cover it.
You will be out of business before you ever get the chance to receive that $30,000.
3. You May Not Be Making Enough Margin on Your Products/Services
In order to have enough cash flow each month (see #2 above), you need to make sure that you are making a high enough margin on the products/services that you sell.
If your margins are too low, or your volume is not high enough, then you won’t have the cash needed to run your business.
Depending on your business model, you may be low margin and high volume (think Wal-Mart) or high margin and low volume (think Lamborghini).
Regardless, you need to know your margin and make sure that it matches your business model and produces the right amount of profit on each item sold.
4. You Can’t Grow With Confidence
Many small businesses get stuck in the “mom and pop” phase.
This often happens because they don’t have the right information to make good business decisions.
One such example is hiring employees. It costs money to hire employees, and if business owners don’t understand the cost (and additional profit created/expenses reduced) from hiring an employee, they will likely never do it.
5. You Have More Stress Than You Should
There is enough stress in being an entrepreneur, so there is no need to add more.
But not understanding your finances will add stress.
Decisions will take longer, and you will likely make some poor ones.
The 3 Main Financial Statements
OK, so now that we have walked through some of the challenges, let’s introduce and review the basic information about the three main financial statements.
Note: Below is the simplest introduction available for these statements. As you can imagine, when these statements are actually produced for your business, they are more complicated and contain more line items with details.
A good starting point after reading this post is downloading our free introduction guide. This guide takes the next step in adding additional detail, once you understand the basics of each statement.
Your business’s cashflow statement serves a simple purpose; it shows you how much cash you start a time period with (ex. a month), how much money comes in during that time, how much cash goes out and how much cash is left at the end of the month.
Below is a very simple example of a Cashflow Statement.
Starting Cash: $1,000
Cash In: $5,000
Cash Out: $3,000
Ending Cash: $3,000 ($1,000 Starting Balance + $5,000 Cash In – $3,000 Cash Out)
By using your cash flow statement, you will gain a better understanding of how cash moves in and out of your business.
Income Statement (Profit & Loss)
Your business’s Income Statement (also known as a Profit & Loss Statement) also serves a simple purpose; it shows the difference between income (sales/revenue) and expenses. If revenue exceeds expenses, the business has made a profit. If expenses exceeds revenue, the business has a loss (for the time period).
Below is a very simple example.
Profit: $4,000 ($10,000 Revenue – $6,000 Expenses)
By using your Income Statement, you will be able to determine if your business is making money or losing money.
Your business’s Balance Sheet shows a financial snapshot of the company at a point in time. If assets exceed liabilities, the owner’s equity is positive. If liabilities exceed assets, then the owner’s equity is negative.
Below is a very simple example.
Equity: $40,000 ($100,000 Assets- $60,000 Liabilities)
By using your Balance Sheet, you will see the current equity of the owners, and as you compare different time periods, you can determine if that number is increasing or decreasing.
How to Use Your Financial Statements to Drive More Profit
OK, you made it this far.
And let me say, I am pretty proud of you.
It can be difficult to take the leap and begin learning about financial statements (especially if they intimidate you), but hopefully, the simple examples above allow you to see that it is not that complicated when you understand the basics.
At this point, you might be asking yourself how you can now use this new found information to help your business become more profitable.
There are a lot of ways that understanding your numbers can help, but here are some of the key ways:
- By understanding your Cashflow Statement, you can see how money flows in and out of your business. This will allow you to see if you have more or less cash available at the end of the month. More importantly, you can do some forecasting out to anticipate how much revenue and expenses you plan to have each month. By making these forecasts, you can then make better decisions about how you spend your cash, as well as take action, such as seeking additional financing if you will have a cash deficiency during a time period.
- By understanding your Income Statement, you will be able to see if the company is profitable or not. Based on this, you can then dive deeper and make some decisions to make it profitable (or more profitable). These can include things like reducing expenses, increased the volume of sales, or increasing the margins.
- By understanding your Balance Sheet, you will be able to see if the company is underwater or not. Based on how assets and liabilities compare, you can make better business decisions, such as paying off some liabilities with profit that the company may have made.
Did You Enjoy This?
We know how difficult it is to run a successful business (we run several).
Hopefully, this post gave you an introduction so that the financial become a little less intimidating, but there is obviously a lot more to your understanding and leveraging your financial statements that we could go into in a single blog.
Let us know what other questions you have about business finances below.