How financial statements help decision making, and how to read them

How Financial Statements help decision making, and how to read them


How financial statements help decision making, and how to read them

When it comes to more complex accounting and financial statements, we tend to always recommend deferring to your accountant, because it’s best to leave it to the experts.

However, that doesn’t mean that small business owners shouldn’t know about what financial statements look like, what’s included in them, and how to read them.

In fact, having the ability to read and interpret a financial statement can help business owners make better business decisions – whether that’s setting better budgets, adjusting prices, assessing partnerships, or rolling out new strategies or product lines in the future.

The tricky thing, however, is that most business owners don’t really find any sort of fulfilment and enjoyment in reading tedious and lengthy financial statements.

Again, that’s what the accountants are for.

When you use the expertise of an accountant or financial advisor, business owners can use financial statements as immensely important leadership tool to aide in decision making.

That said, are three financial statements that every small business owner should understand, and that ultimately impact their ability to lead, and make more well-informed decisions.

  1. The Income Statement
  2. The Cash Flow Statement
  3. The Balance Sheet

In this article, we want to cover three of the most common financial statements, how they can help you as a business owner make better business decisions, and how you can interpret those statements.

Income Statement

The income statement is widely regarded as the most common (and sometimes, the most important) financial statement out there.

Even though you’ll see in this article that all of the statements are important in their own regard, the income statement is definitely up there.

The income statement also goes by a few different names, more commonly including the profit and loss statement (or, the P&L for short).

Nevertheless, the income statement or P&L shows the sources and breakdowns of all revenues and expenses in a business for a certain period of time – which, can be monthly, quarterly, yearly, both present and in the future (which, we refer to as a P&L Forecast).

The income statement is a simple top-to-bottom read, showing your different expenses and revenue sources as you go down the list – followed by the net profit (the number we’re all looking for) at the very bottom.

Some of the important things that are noted throughout the P&L statement include:

  • Revenue sources
  • Cost of goods sold
  • Gross profit and net profit
  • Expense items
  • Operating income
  • Pre-tax income
  • Interest payments
  • Sales, general and administrative expenses

Now, it’s one thing to know what each of these means, but it’s also important to know some important ratios and formulas on how these different numbers and figures work together.

Here are the top 4 ratios that, as a small business owner, you need to be aware of on your income statement:

  1. Gross Profit = Revenue – COGS
  2. Operating income = Gross profit – SG&A
  3. Pre-tax income = Operating Income – Interest
  4. Net profit (also known as your bottom line) = Pre-Tax Income – Taxes

These four formulas generally give you the overall health of your small business, and although the bottom-line net profit is a good figure to keep in the black, you always want to understand the importance of other ratios as well.

Here’s our top suggestions on how to better understand your income statement:

  • Watch your revenue figure, as it increases all incoming figures for the better throughout the whole statement. We always suggest that keeping an eye on revenue is a great way to also understand the overall health of the business. If you’re generating revenue, that’s the first step to success.
  • Keeping COGS low not only means that you’re operating at a surplus of revenue, but it also lead to higher operating income and better financial health over time. Not only this, but it can also act as an indicator of overall lean business management and effective cost management. Low costs plus high revenue means great profit.
  • SG&A can be minimized by reducing your expenses and targeting marketing campaigns effectively to increase your overall profitability. In other words, run your business efficiently

When it comes to the last couple expenses we mentioned—interest and taxes—that you as a business owner consult with an accountant. The reason for this is because there are always many different rules and regulations, as well as a tonne of financial opportunities surrounding tax and interest.

In other words, if you manage these wrong, you could lose money. If you manage them right with your financial advisor, you could keep some money in your pocket.

We’ve compiled a few more ratios that help you better understand the overall financial health of your small business.

  • Gross Profit Margin = Gross Profit / Total Revenue
  • Operating Profit Margin = Operating Income / Total Revenue
  • Net Profit Margin = Net Income / Total Revenue

Cash Flow Statement

Next to the income statement, one of the best indications of liquidity and the overall status of profitability in a company is the cash flow statements.

According to most sources, here’s what we define the cash flow statement as:

The cash flow statement provides a detailed picture of what happened to a business’s cash during a specified period. It also demonstrates a company’s ability to operate with (or, without) liquidity today and in the long-term. In short, the cash flow statement is as assessment and summary of how much cash is flowing in and out of the business.

On most other financial statements (like the income statement), there’s no indication to show the cash going in and out of the business.

This can pose a problem, because although the income statement and balance sheet might show the overall health of the organization, they don’t always how the company is generating money, and where that money is going.

This is where we see the cash flow statement provide clarification to business owners.

Let’s look at an example to demonstrate how the cash flow statement works.

If your local Vancouver florist business makes a sale, the customer owes money and the income statement recognizes revenue. However, a business can’t spend that money until the customer pays.

For a small business, this receivable could be a nightmare, because there’s a delay on when the company earns that money.

Say, for example, this small florist business has $1,000 of outstanding invoices it’s going to receive on the 30th of the month, but it’s bills of $500 is due on the 15th.

The income statement will show you that the business has enough money to pay those bills.

However, in reality, there’s a lag time that may result in the company leaning into other sources of income, or debt, in order to pay those bills.

This is where the cash flow statement comes in.

The Cash Flow Statement can show a small business how much money was generated from operations and how that cash was used.

What we’re really trying to say is this… Even if your income statement shows overall good health, if you don’t have cash… You’re in trouble down the road.

This is why it’s important to keep an eye on the cash flow statements, because if you see that your cash flow is like a roller coaster from one time frame to another, you should take a closer look at where in the company the cash is moving – because that may be a sign of losses in one area of another.

So, how do you read the statement? Well, they’re pretty intuitive, with period and other specific details included and broken down so you can watch trends.

Really, if you see a specific total that doesn’t add up, check the breakdown and see which areas are incurring heavy losses or gains.

Balance Sheet

The last financial statement that we have for you small business owners is the balance sheet.

The balance sheet, simply put, is a list of all of a small businesses’ assets and liabilities, and can be one of the greatest tools for forecasting and projections, and decision making in a small business or growing business.

The balance sheet has three main areas, two of which really apply for small businesses that may not have shareholders.

These two areas are assets and liabilities, and can be broken down into short- and long-term (also known as current and non-current), intangible and tangible, as well as a few other categories.

Current assets would include things like cash, receivables, inventory, and short-term repayments. Essentially, anything that makes you money in the short-term (usually less than a year).

If you have a lot of incoming receivables and long-term repayments this is an indicator of more long-term sustainability and profitability because you’re not only covering your expenses today with cash, but you’re also generating income tomorrow and in the future.

Other non-current or long-term assets would include things like buildings, equipment, and long-term loans that may generate income in future years. This also helps indicate future profitability, but it’s important to strike a balance with current and non-current assets, because you can’t be profitable tomorrow, if you have no money today.

Nevertheless, the best way to read the assets is that you want a balance between current and non-current, and you also want more assets than liabilities.

Most current liabilities would be things like payables, debt, and deferred revenue. These are expenses that are getting taken out of the business.

You generally want to manage this but understand that no liabilities isn’t always a good thing. This is because liabilities include things like wages, taxes, unearned revenue, and sometimes capital investments.

In other words, if you have no liabilities, it probably means you have almost no assets, and no growth.

Again, though, the sign of a health company is that you have more assets than liabilities.

This, then brings up the third component of a balance sheet – the retained earnings. This is an excellent indicator of growth, because retained earnings represents the amount of money that has been earned and reinvested into the company and equals the different between assets and liabilities.

If you have fewer assets than liabilities (which, should be impossible), then something is wrong in the business, and you’re probably dipping into your reserves to make ends meet.

If you have high retained earnings (respective to your liabilities) this probably means that you have excess net profit, and can re-invest this into the company, signifying long-term growth.

One ratio that is important to know is the current ratio, which is current assets divided by current liabilities. If this is greater than 1, it means the company is healthy and can meet its short-term obligations and financial requirements.

Now, of course, we always recommend that you defer to your accountant or accounting firm to help in understanding financial statements. That’s why we’re here! For over 30 years, Valley Business Centre – Bookkeeping & Payroll has been providing comprehensive bookkeeping, debt management, and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor and metro Vancouver B.C. areas. Valley Business Centre – Bookkeeping & Payroll provides reliable and effective services to all clients.

Disclaimer

This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulation may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions



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