All small businesses differ slightly in their operations, environment, and methodology — making it challenging to measure business performance from a single, universal approach. What many entrepreneurs don’t realize, however, is that they can use financial statements for much more than supporting documents on loan applications and tax returns. Regular preparation and analysis of financial statements can provide small business owners with the basic tools for determining how well their operations are currently performing, help them detect/correct problems and leverage opportunities, all leading to increased profits.
In this article, we will discuss the importance of financial statement analysis for small business owners, the different types of financial statements, and how to effectively use financial data to make well-informed decisions.
The Importance of Financial Statements for Small Business Owners
Smart small business managers and owners rely heavily on the figures and conclusions drawn from their financial statements. Without preparing and analyzing your financial statements on a regular basis, you are basing many of your decisions on guesswork or vague perceptions of how your business is doing. It is standard practice to prepare financial statements monthly.
With this information, you can begin to determine the financial health of your business (cash flow, product line profitability, gross margins, liquidity), identify current or potential problem areas and identify successes. With this information you can take measures to improve your business, from making additional investments to supporting promising products to eliminating unprofitable lines of business.
Financial statements also allow you to see where your business is in danger. Just because your small business’ sales are increasing doesn’t necessarily mean the business is financially stable and it doesn’t guarantee continued success. Some of the chief causes of small business failure, including high operating expenses, poor cash management, excessive working capital investments and inventory mismanagement, could all be identified/mitigated by reviewing and understanding your financial data early-on and using the information to make course corrections.
By reviewing comparative data across periods, for example, it is possible to identify where spending has gotten out of control. On the other hand, these reports can also help you spot buyer trends and see where you make the most money, allowing you to focus more fully upon those areas that drive increased profitability.
Four Types of Financial Statements
There are four basic types of financial statements. You’ll want to make certain that you utilize all of them in order to get the most out of your financial reporting. Below are the four types of statements:
- Income statement
- Balance sheet
- Statement of changes in equity
- Statement of cash flow
Let’s take a look at what these financial statements can be used for and how they can help you in running your small business.
An income statement, sometimes called “a statement of income and expense” or “a profit and loss statement (P&L),” is a summary of income or loss for the period. A typical income statement would be structured as follows:
- Revenue recognized for the period, often broken down into its various sources
- Cost of returns or costs due to defective goods
- Cost of goods sold (COGS)
- Gross profit (net sales – the cost of goods sold)
- Operating expenses, often referred to as selling, general and administrative expenses (SG&A)
- Operating income (gross profits – operating expenses)
- Non-operating revenue or expense (commonly might include interest income or expense)
- Pretax income (operating income or expense), and
- Net income (pre-tax income less income taxes due)
It is important to understand that the income statement shows results for a period of time (a year, a month, a quarter) and that it “starts over” every period. By comparing the income statements for the past several years or periods (if comparing month-to-month), you can see trends and anomalies. These observations can then be studied further to understand the cause and determine if there is some action that could be taken to improve the business.
A balance sheet shows all of your company’s assets and liabilities, along with its net worth. It might also be called a statement of financial position. The balance sheet is a snapshot in time. It illustrates balances at a moment in time (i.e. at month-end or year-end). Unlike the income statement, which shows results of a period of time (i.e. a year, a month, a quarter), information from the balance sheet is used to estimate the liquidity, funding and debt position of an entity, and is the basis for a number of liquidity ratios.
Your balance sheet relies on the following equations:
- Assets = equity + liability
- Equity = assets – liabilities
Balance sheets typically classify assets as current assets (those that can be converted to cash within a year) or non-current assets (long-term investments, equipment and other fixed assets, and other assets (such as intangible assets). The same current versus non-current classification is performed with respect to liabilities.
The equity section of the balance sheet shows the company’s “net worth” (assets less liabilities). This should not be confused with a company’s economic worth or value. Often assets and liabilities have different market values than those recorded on the balance sheet. Most assets and liabilities on the balance sheet are stated at cost (what you paid for them, rather than what they are “worth”).
The balance sheet is often used to determination the financial stability of a company. From this statement one can understand how leveraged a company is, what resources it has to pay its bills and its general financial health.
Statement of changes in Equity
This statement rolls forward the entity equity for the period. It takes the equity at the beginning of the period and either adds or subtracts from it, depending on the company’s net income or loss, as well as accounting for things like dividends or distributions to shareholders.
Statement of Cash Flow
The statement of cash flow shows where your cash is coming from and where it is going over the course of a period of time. Like the income statement, this statement shows activities for a period of time versus a point in time. This statement starts with your beginning cash and shows the cash used or generated from various activities. These activities are split into three categories – operating, investing and financing activities.
Operating activities represent cash generated from or used for things such as buying inventory, selling your goods or services and paying employees. Investing activities represent cash generated from or used for things such as buying or selling equipment, buildings or land. Financing activities represent cash generated or used in activities such as selling or redeeming stock or issuing or paying debt.
This statement is crucial in trying to understand where cash is coming from and where it is going. Many say “cash is king” and this statement tells how a company makes its cash and how it spends its cash. In some instances a company can make certain decisions to manipulate its balance sheet or income statement; however, one cannot fake its cash flow.
How You Can Use Financial Statements as Management Tools
You can use financial statements when making a number of different decisions. For example, you can see what investments your company has made and what kinds of returns you are receiving on those investments. If you added another $10,000 to your marketing budget, did you see an increase in sales? If you cut your operating costs by 10%, how much of an effect does that have on your bottom line? Financial statements can help answer these questions.
Financial statements are also useful for highlighting the natural rhythm of your business. Every industry has high and low points throughout the year. If you sell toys, for example, you’ll likely see a high period of sales between mid-October and January in accordance with the holiday season. If you sell clothing, you’ll note an increase in the sale of swimsuits, shorts, and other summer gear starting around May. Using your financial reports to see these natural high points can help you determine when you need to increase your stock or expand your advertising efforts or when you may need to borrow money.
Owners and managers can use financial statements to ask and answer important questions about their businesses. Is a company generating a strong investment return? All you need to do is look at your operating income and divide it by the business’ invested capital (working capital + fixed capital) to determine what return you are earning. How much capital are you tying up in working capital as a % of sales? How leveraged is your company? How is a product line doing? How long does it take you to collect receivables? These are all important questions that can be answered by having and using timely and accurate financial statements coupled with analysis.
Using these Financial Reports Together
Individually, these four financial statements can tell you some information, but it’s when they’re used together that they really give you the information you need to make the best decisions. It is important to understand each statement. Each tells you something important that you might not get from focusing only on one or two of them.
Many times small and mid-sized business owners are experts in a product, sales or manufacturing and do not have the financial skills or the time to properly focus on the company’s financial matters. In these instances, you may want to bring in an outside consultant or a fractional CFO. These part-time financial experts can help small and mid-sized businesses make smarter business decisions, without the expense of hiring someone full time. Insightful business and financial analysis will lead to a stronger more profitable business. Contact Lauber Business Partners today to learn more about these options.