Q: Why do I need to create these financial statements when I know I’m making money?
A: Some business owners feel that cash in the bank proves that they are doing well and a bank statement is all they need to prove they're profitable. While the “cash is king” mentality is common, it is only one page of your company’s story. Your financial statements aren’t just for you. You have to expand your view include key stakeholders outside of your business. When telling your company’s story to these stakeholders, you will need financial statements to tell the full story. For example, if you want to borrow money to expand your business or complete a big project, lenders want to see proof that you’ll be able to pay them back. Or, if you want to attract new partners or a few shareholders, potential investors want to know that the business is making money from its operating activities. However, the most important user of your financial statements is YOU! The financial statements are an important tool for making quality management decision. There are several key financial metrics which can be derived using your Income Statement and Balance Sheets. One thing to note before you begin is the results will vary based on the basis of accounting you are using. The cash basis will recognize revenue based on when cash is received. Accrual basis will recognize revenues based on when it is earned (even if it is received later).
Q: Is there one statement in particular that I need to start using right now?
A: Each financial statement tells a different part of the story and each is important. If you were going to start with just one, I’d recommend the Income Statement (I/S). The Income Statement (also called Statement of Profit and Loss, or P&L) shows revenue and expenses, as well as other gains and losses. This statements covers a period (i.e. the Month Ended October 2016 or Q4 2016). In deciding how often to produce your statement, just remember that it should be frequent enough that the data is still relevant. A best practice approach would be to create the I/S monthly (I’d suggest it’s created at least quarterly). The Income Statement does not cover multiple years. At the end of your fiscal year the Income Statement is closed to Retained Earnings (a part of Owner’s Equity on the Balance Sheet).
Q: Does a small business really need a Balance Sheet?
A: The short answer: Absolutely! The Balance Sheets give a lot of valuable information that the I/S doesn’t. Unlike the I/S which starts over each year, the Balance Sheet is an Inception-To-Date report and can be used to track your company’s position since it began. This statement shows assets, liabilities and owners’ equity. Assets consist of anything the company owns which can provide a benefit in the future such as cash, accounts receivable or a building. Liabilities represents any obligation which must be paid in the future like debt, accrued interest and payables to vendors. It includes the obligation to perform work in the future when a client has paid in advance. Owners’ Equity is the remaining value which belong to the owners, partners or shareholders (Asset – Liabilities = Owners’ Equity). The Balance sheet is taken at a moment in time (i.e. as of November 30th 2016) and is a “snapshot” of how the business is doing at any moment. (Remember: the I/S covers a period of time). As I already mentioned, at the end of each year net gains or losses from the Income Statement are closed out to the Retained Earnings (a part of Owners’ Equity). Thus, this section of the Balance Sheet can be thought of as your cumulative Income Statement from Day 1 to present.
Q: What else should I be monitoring?
A: I can’t overstate the importance of “Budget to Actual” variance reports. These reports can be used for Income Statement accounts (like cost of sales) or Balance Sheet accounts (like cash). It will show you where you are compared to where you planned on being. Then you can begin the important part – finding out why you missed your mark and what you plan on doing differently. The Statement of Cash Flows is another report that can be important to your business. It shows you how your company is using its cash. The report is broken into three sections: Operating Activities (your primary business functions), Investing Activities (purchase/sale of long term investments and property, plant and equipment) and Financing Activities (borrowing/paying debt and interest or the purchase/sale of your company’s stock, bonds and dividends).
There are also key financial ratios which can be derived from your Income Statement and Balance Sheet which can provide insight about your company. First, there is the Profit Margin Ratio (=net income/net sales). This shows how much of your sales actually make it to your bottom line (instead of being eaten up by expenses). Here, the higher the number, the better. It’s necessary to incur some expenses to produce revenue. However, if you are losing too much of sales to expense, it’s time to reevaluate. Current Ratio (=current assets/current liabilities). Your current ratio will tell you how much liquid assets (like cash) you have available to pay liabilities which will be due soon. This is vital to making sure your company remains solvent and does not get too many of their liquid assets tied up. Debt to Equity Ratio (=debt/owners’ equity). This will show how the company’s leveraged (how much debt is used to finance assets relative to the owner’s value). The higher this number is, the more risk the company has taken on. While taking on debt on order to grow your business can be a good choice, you want to be sure that the increase in revenue is more than the increase in interest. You also need to separate revenue increases related to debt from other things that could increase revenue (like a new advertising campaign).
Still have questions about financial statements, just call your CPA (281) 410-1404