It often feels like a person needs to be a CPA to understand financial statements and what they represent. For more complex institutions that isn’t a completely untrue statement. But most small business owners don’t have all that complexity, nor do they need it. Additionally, if they can’t understand their financials, then what value do they have for them?
We are going to take a simplistic look at financial statements, what they represent, and what they mean to the business owner.
There are three main financial statements for small business owners:
- Balance Sheet
- Profit and Loss (P&L or Income Statement)
- Cash Flow statement
What is the balance sheet in one sentence?
The balance sheet is what you have.
The balance sheet format is based upon the foundational accounting formula of:
A = L + SE
Assets = Liabilities + Stockholders’ Equity
This is why it is called a “Balance” sheet, because they have to balance.
Assets are things.
Liabilities are what is owed.
Stockholder’s Equity is what you own. Remember that what you own is also seen as the difference between Assets – Liability = Stockholders’ Equity.
Profit and Loss
What is the P&L in one sentence?
The P&L is what you have done.
The format for the P&L is:
Revenue – Expenses = Net profit or loss.
Expenses gets further broken down into Cost of Goods Sold (COGS) and Operational Expenses.
COGS is the expenses directly related to the creation of whatever gets sold. If you are manufacturing widgets, that means the material used, and the labor of the manufacturing staff on the floor. But that won’t mean the accountant’s labor or their printer paper. A simple rule of thumb is that if isn’t a direct input to the product it is classified as Overhead. That is another topic so we will focus on the high level stuff. A service based company will have a lot lower COGS compared with a manufacturer.
Operational Expenses are those expenses that exist, but aren’t direct inputs to the creation of the widget. Sales expenses and admin expenses fall into this category.
So, revenue is the money that you get paid.
When it is presented on the financials there is Gross Profit, then Net Ordinary income, and finally Net Income.
Gross Profit = Revenue – COGS
Net Ordinary Income = Gross Profit – Operational Expenses
Net Income = Net Ordinary Income -/+ Other income (Sale of an asset or non ordinary business income)
Cash Flow Statement
What is the Cash Flow Statement in one sentence?
I said it and I meant it. Everything up to this point has been a collection of different ways to look at information and try to turn it into something of value. But nothing means more than cash in and cash out.
When we were helping a client get an idea for the value of their business it wasn’t the balance sheet or income statement that we used. It was the cash flow. Because if a $1 million dollar asset doesn’t make a dollar for the owner, it is worthless. Same with income, if there is $1 million worth of net income and not a single dollar of cash flow then it is also worthless.
The Cash Flow statement is also the hardest one to prepare. Either have your software do it, or ask your accountant to help you with it.
Knowing that I’m going to oversimplify this, the Cash flow reconciles the Net income, to the changes in the balance sheet. Effectively cutting out all the accounting fluff.
The Cash Flow statement breaks down activity into 3 oversimplified parts:
- Operational activity – Business activity (Normal business operations)
- Financing activity – Borrowing or lending, or purchase/sale of assets (Think bank loans)
- Investing activity – Business investment (Cash from or to investors)
All of this is done by noting the changes in the balance sheet, not the actual balance. Because if your inventory went from $500,000 to $500,000, there may or may not have been any cash spent on it. But if it went from $500,000 to $600,000, there was a change of $100,000 which would not have affected net income, and needs to be considered as a decrease in cash flows.
Lets recap, your balance sheet tells you what you have, your P&L tells you what you did, and your cash flow statement tells you the truth. We will talk further at a later date about how you can use each date to make business decisions, but for now we hope that helps.
Best of luck.
Disclaimer: The information contained in this document is provided for informational purposes only and should not be construed as financial or tax advice. It is not intended to be a substitute for obtaining legal, accounting, or other financial advice from an appropriate legal professional, financial adviser or for the purpose of avoiding U.S. Federal, state or local tax payments and penalties.