Confession time! I graduated from my Bachelor of Commerce program barely able to read a financial statement. I knew what they were, but they always seemed too abstract to spend a bunch of time getting to know. Besides, my thinking was that they could be manipulated to show what the company wanted to show (this was during the Enron scandal).
It wasn’t until I pursued my Chartered Accountant designation that I started to see how they came together like a puzzle and what their purpose was. I could look at them and draw some meaningful insights, but they still seemed theoretical in a way.
It wasn’t until I owned a business of my own that I really started to see how powerful they could be. I saw my assumptions reflected in black and white. My decisions from 3 months ago came to fruition in the numbers (for good or bad). I could plan and take risks from a position of strength or correct a position of weakness.
Ask any great entrepreneur and they know how to read their financial statements. They know what that blip from the middle of last year was and they’ll tell you how they corrected it. Understanding your financials is absolutely critical to running a successful business. So, here’s the basics - your financial statements and what they are for.
This is a football. - Vince Lombardi, NFL coach, to his training camp players
Accounting is an art
No, I am not smoking anything. We often have to do a bit of expectation management when we get a new client. Some business owners think of accounting as strictly a problem to solve, but there’s a lot of art involved in creating financial statements.
Take revenue, for example. A customer comes into a store and pays for an iPad. Simple, record the sale as revenue and you’re good to go, right? Well, what if 29 days later, the customer brings it back for a refund. Was it really a sale? What if we can predict the percentage of returns we expect? Now we are in the world of estimating the present based on what we expect in the future. Art.
These scenarios permeate accounting. We like to think of the numbers as being black and white, but what I want you to take from this section is that financials are full of nuance. That doesn’t mean they can’t be relied upon, but it’s not just math.
Bottom Line: Understanding that accounting is an art helps you understand the context of your financial statements.
The Income Statement (and what profit really means)
The income statement is also known as a profit and loss statement - and for good reason - it shows your profit or loss for a given period. We like to see monthly income statements with comparatives as well as a rolling 12 months so we can see a full business cycle. It should also be deadly simple so you don’t go cross-eyed. With tools like Xero, you can always drill down if something looks off.
At the top of the income statement, you’ll see the star of the show - Revenue. This is the sales that were completed in the given period. This may seem obvious, but the issue becomes recognition. In services companies invoices often happens well after the service was performed. For construction companies, there may be milestone payments that don’t necessarily align perfectly with the work completed. Strictly speaking, the revenue has to be “earned” in order to be recognized here.
It’s not always simple to know what to record for revenue. For most small businesses, it’s about consistency. You may be tempted to show low revenue for tax purposes and high revenue for an upcoming loan application. These are distractions. Your operations are your #1 concern. Set a policy that makes sense for your business and stick to it so you can manage your finances properly.
Cost of Sales + Direct Labour
These are costs that are directly related to producing your product or delivering your service. They go up in direct (or nearly direct) relationship to your sales. In manufacturing, examples would be production labour, raw materials, and all direct expenses that would go into the products (shipping, manufacturing electricity, etc.) Typically, you don’t have a lot of control over these expenses. You might be able to negotiate a bit or find ways to get more efficient.
Gross Profit (The real star)
Our first calculation! Subtraction to start: Take your revenue and subtract your cost of sales/direct labour and you have your gross profit. You can brag about your revenue all you like amongst your friends. When you are evaluating your company size, you should be looking at your gross profit number because this is where you can make or break your business.
You can be a $20 million dollar business with $15 million in pass-through subcontractor expenses. I would argue that you are actually a $5 million company and what you do from here to the profit line is what really matters.
Your operating expenses cover all the things you need to spend money on to run your business: table stakes. Here are the big ones:
- Labour - all the people you need to pay to keep the business running
- Marketing - the money you spend to keep the sales coming in.
- Facilities - the tools you need to do the work.
- Other operating expenses - this is a capture-all and will vary by business what goes in here. It should be consistent and should be investigated regularly to understand what is going here.
Pre-tax Profit (Loss)
Your gross profit less your operating expenses is your profit. We’ll go over what your should be targeting a little later. The government is going to take their cut, but that’s okay. Successful companies pay tax. Get over it.
Bottom Line: Your income statement should be really simple (less than 10 items). Consistency in how you recognize revenue is going to allow you to make meaningful comparisons in your performance. Don’t get rattled by month to month changes - looking at a rolling 12 month income statement is much more meaningful.
The Balance Sheet Tells the Story
Looking at the income statement by itself is dangerous. You can look at an income statement and see all the good things (high revenue, low costs, big profits), but without the balance sheet it could be hiding some dirty little secrets. If that high revenue isn’t translating into cash in the bank or if those low expenses consist of labour that is going into “capitalized labour” or other sneaky tricks, you would completely miss that the business is in a “pants-on-fire” emergency.
This is why the balance sheet plays such an important role in understanding a business. It’s called a balance sheet because it always balances: assets that you hold = what you owe + what you own. Or as you may have seen before Assets = Liabilities + Equity.
Assets are all the things that you hold. This can be cash, accounts receivable, inventory and equipment. In order for them to be true assets you must control over them. For example, if you have inventory that you haven’t paid for and isn’t in your possession, it’s probably not your asset yet.
Liabilities are all the things that you owe. You may have bought a piece of equipment with a loan. You would have an asset as you hold that piece of equipment and you would have a liability because you owe the bank cash for the loan. Other examples of liabilities are accounts payable, taxes payable, shareholder loans and lots of others.
Equity is what you own. When you take all the cash, accounts receivable, etc and subtract everything you owe, it stands to reason that the leftover amount is what the owner actually owns.
Here’s where it can get a bit tricky - you may have assets that aren’t really purchased or physical, but are built over time. Take your brand, for instance - it’s got value, but you haven’t purchased it with money (likely). You have earned it with good customer service, superior products and social credit. This is called goodwill and now you see the limit of accounting.
Without a transaction to back it up, goodwill is generally not recorded on your financial statements. You need to interpret the value of your business by other means.
Bottom line: The balance sheet may not be the star of the show, but without understanding it your income statement could be hiding some dirty secrets. It’s not perfect though - your balance sheet equity may not show the full value of your business as it doesn’t show the goodwill you have built in your business.
Cash Gets Its Own Statement
The final statement that’s often included in a financial package is a cash flow statement. The purpose of this statement is to bridge the gap between your balance sheet and income statement by showing the activities of your most important financial item: your cash.
A good way to think of your cash flow statement is a cash-basis income statement. It should show your cash generators and your cash usages. You can see where your cash is actually coming from. The piece that makes it different from the income statement is that it will include more than the operations. You will see loan payments and purchases of equipment, etc.
Bottom Line: Since cash is your most important financial item, it gets its own statement. It shows you when your cash is coming from and going.
How It Comes Together
The financial statements work together. Reading one without the others can lead to some poor decisions or incorrect insights. Understanding how they work together in your business doesn’t happen overnight. That’s why we spend a lot of time educating our clients about what they numbers mean. Often, they know the number they want to see, but aren’t quite sure how to express it. It’s our job to tease that out and get the information in their hands that they need to grow a successful business.
Interested to hear how we get good information to you about your business? Break the Ice now and we’ll take the time to get to know your business and show you how we might be able to help you achieve the growth you want.