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Financial Statements 201

Financial Items

In another post, I provided a basic explanation of the three essential financial statements. Let’s go a little deeper to see another reason why they are so helpful.

It is interesting to me to observe the causal nature of certain business drivers and how small changes can over time can significantly affect cash and net income.  Many business drivers are interconnected through the financial statements.  For example, a strategy to improve inventory turnover can have a dramatic positive effect on cash (the balance sheet) and may have a positive or negative effect on profitability (the income statement), and a positive or negative effect on customer service through fill rates and on-time deliveries.

Understanding the basic financial statements is not only helpful for business owners for the obvious reasons, but can also aid in more in-depth scenarios like these, to name a few:

  • investors looking at a P&L
  • doctors running a medical practice
  • sales reps considering customer profitability and gross margin
  • accounting staff discussing the de-leveraging the company or evaluating credit worthiness of customers.

Simply put, understanding financial statements can help you ask meaningful questions and make well-informed decisions.

For example, I analyze P&L performance compared to the established business plan and to prior year results.  What were the sales and profit drivers vs. expected and compared to historical sales and profit drivers?  What were the expense fluctuations vs. expected, and what can be changed to improve results?

Similar for the balance sheet and cash flow statement, I look at the cash flow and liquidity metrics results to compared to expectation.  What improvements can be made for improvements for asset velocity and cash flow? How can we maximize effective leverage?  See my resources for some basic ratio ideas.

This information leads to small improvements over time which can yield incredible results.  For one client, I finished a small project with the goal to improve cash flow and reduce credit risk.  We put in a basic credit application process and worked to improve accounts receivable turnover.  Over the first four months, a one-person accounts receivable department improved their days sales outstanding average by five days.  Over the next year, she reduced accounts receivable turnover another five days.  Based on their growing top line with 100% open credit terms, they company had a $150,000+ positive impact to cash as a result of that small project.

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But I’m not an Accountant!

Why every business owner still needs to understand basic financial statements

financial statements

I recently conducted a workshop for start-up businesses and young entrepreneurs.  I was fascinated by their limited knowledge of the basic financial statements.

As an accountant by trade, I see how important it is for business owners to understand the three basic financial statements: the income statement, balance sheet, and cash flow statement. Grasping these allows owners to assess the company’s financial strength, maximize profitability and determine creditworthiness.

All companies should have solid closing procedures to get quick, accurate results, and they should spend time to review the financials in depth every month.

Here are the three basic financial statements, explained simply:

Income statement.  Also known as the P&L (Profit & Loss) statement, shows revenue, expenses and net profit over a certain period of time.  Net income is zero’ed out annually and moved to what is called “retained earnings” (which is another balance sheet account and basically means funds that you have set aside.)  At the beginning of the new year, you start pushing the ball up the hill again.

Balance sheet. This shows your assets, liabilities, and net worth at a snapshot in time.  It shows what you own and what you owe on a particular date.  The assets and liabilities are listed in ‘ease of liquidity’ order. Liquidity refers to how quickly you could turn those assets into cash.

Cash flow statement. This shows sources and uses of cash categorized by operating activities, investing activities, and financing activities. (In other words, income from sale, income from investing, and borrowed funds.)

These three statements will go a long way toward indicating the health of your company at any given time. To go further, you might want to take a look at a great book by Dick Purcell, Understanding a Company’s Finances with the Financial Picture by Dick Purcell.  I use Purcell’s concepts to show the basic business cycle accounting flow all the time.  A picture is a thousand words.  In his book he provides a diagram that does an excellent job explaining the basic financial statements.

I am always surprised by the business owner who doesn’t have a firm grasp on their numbers or who do not understand the balance sheet.  I hear, “I’m not an accountant” a lot.  Successful business owners understand their numbers.  They get the relationship with the balance sheet and cash flow statement.  They don’t tolerate a slow month-end close or inaccurate numbers.

Keep watch on your basic financial statements. They are vital signs to see how well your business is performing, and help you make needed modification to improve it.

Need additional help? Contact me. Be sure to subscribe to my posts to receive my free checklist, 7 Keys to Better Cash Flow.