After many years of working with thousands of Small Businesses, I have noticed that finance is often an área of weakness for small business owners. They say that the language of business is finance, but unfortunately, most small businesses do not fully understand this language.
What is even more critical, they don’t fully understand how to read their financial statements. The myth about understanding finances is that it is difficult, that only people with extensive formal studies in accounting, finance and management can understand finance well. This myth came about because most people who learn finances do so in college or technical schools, and most of these schools prepare their students to work in the financial departments of large companies, not to manage the finances of a Small Business. Unfortunately, trying to adapt best business practices of large companies to a small business almost always results in failure.
Reviewing your finances without understanding what they mean is like driving a car without knowing what the car dashboard indicators mean. Imagine that the oil change indicator lights up and you don’t know what it means, so you continue driving the car. Eventually, your motor burns out and your car stops running! The results can be just as bad when small business owners and entrepreneurs misunderstand their financial statements.
I can tell you that to understand finance you only need to know how to do 4 things: add, subtract, multiply and divide. That’s all, you do not need more! Below is a simple explanation of the 3 critical financial statements. But first, be aware that even if your accountant or bookkeeper prepares your statements for you, the best situation is for you to work in partnership with your accountant. Discuss with him/her how you want your financial statements presented, what level of breakdown you want to see, how much detail, in what format, etc. This can be critical to your understanding of what is happening in your business.
3 critical financial statements:
1. Income statement:
This statement tells us how much the company earned, how much was spent and how much remained.
It’s simple: revenues – costs – expenses = profit.
In a more common format:
Sales – Cost of sales = Gross margin
Gross Margin – Expenses = EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
EBITDA – interest and depreciation = Profit before taxes
Profit Before Taxes – taxes = NET profit
2. Balance Sheet:
This statement shows your assets, liabilities and shareholder’s equity (net worth). In other words, how much I have, how much I owe and how much wealth the company has generated.
The balance sheet will always “balance,” since Assets = Liabilities + Equity. If your assets are greater than your liabilities, then you will have positive shareholder’s equity. If your liabilities are greater than your assets, you will have negative shareholder’s equity.
3. Cash flow:
Cash is the lifeblood of any business. Without cash, you cannot operate. While your accountant or bookkeeper can provide you with monthly statements, this is the one statement that I recommend you maintain yourself, within your business. Keep an excel spreadsheet that keeps track of the cash flowing in and out of your business. You do not want to find out too late that you don’t have the cash to pay your bills or your payroll.
Just because your “sales” are high, do not assume you are in a good cash position. If your receivables are very high, you might have a situation where your customers all owe you a lot of money, and you don’t have enough cash to pay your bills! If this is perpetually the case, it would be a red flag to review your customer payment policies.
One last comment, no one is born understanding finance. Like everything in life, we need to learn it, and then practice it to truly understand the “language of business.” The more you review your financial statements, the better and better you will understand them.