Financials and financial strategy can be the most complicated aspects of running a business, but only if you don’t understand the basics.
What follows is part one of my primer on financials for business owners – what you absolutely need to know to begin to become fluent in the numbers behind the profitability, sustainability and value of your company.
The Format of Your Financials
Producing the right financial documents not only helps you run your business more effectively day to day, but also is critical for achieving big picture objectives such as obtaining funding for growth, and for gaining valuable decision making information such as how profitable each of your products and/or services is.
This is why the first thing every business owner needs to know is that the financial statements YOU receive need to be based on managerial rather than cash accounting.
Managerial accounting information helps leaders makes decisions, while cash accounting provides outside accountants with what they need for tax planning and preparation.
Your company’s financials should be on an accrual basis, essentially meaning that revenues earned are matched with expenses incurred.
Now that you understand the format and basis of your financial statements, let’s move onto the actual documents you need.
The 3 Financial Documents Every CEO Needs to See
Balance Sheet: Your Balance Sheet gives you a snapshot of your company’s assets, liabilities and owners’ or shareholders’ equity at a specific point in time. In other words, it’s a picture of what your company owns, owes and how much is invested. This is an often overlooked, misunderstood, yet very important piece of the financial puzzle.
It’s called a Balance Sheet because what your company owes and has invested has to equal what it owns:
Liabilities (what your company owes) + Equity (how much owners/shareholders have invested) = Assets
If your Balances Sheet doesn’t “balance out,” you haven’t collected all your financial information or recorded it correctly.
Profit and Loss Statement (a.k.a. Income Statement): Your Profit and Loss Statement is a summary of your company’s revenues, costs and expenses over a period of time, usually a month, quarter or year.
It is a key financial document because it allows you to project profit and expenses and analyze how well your company is buying or selling inventory (or services) to make a profit.
To determine your company’s gross profit:
Total Sales – Cost of Goods Sold = Gross Profit
To determine your company’s Gross Profit in the above equation:
Gross Profit – Total Operating Expenses = Net Profit
Cash Flow Statement: Your company’s Cash Flow Statement summarizes how much cash was received and paid out during the period and essentially reconciles an accrual based financial statement to a cash basis. It illustrates overall changes in cash and is an important component of your financial picture. It’s important to note that there are sources and uses of funds and a lot of this action shows up on the Balance Sheet and not on the Profit and Loss Statement.
Usually a Cash Flow Statement starts with the profits earned (on an accrual basis) for the period, adjusted for non-cash expenses such as depreciation.
Adjustments are made for increases or decreases in balances of accounts receivable and accounts payable, as an example. If accounts receivable increased from the prior period, the company didn’t receive all of the revenues it recorded on its financials in cash. Therefore, this is a reduction, or use, of cash. The opposite is true of accounts payable (an increase would mean the company hasn’t paid all of the expenses recorded on its Profit and Loss Statement).
Inflows and outflows from financing activities are separate sections on the Cash Flow Statement. Inflows from financing might include an increase in a line of credit. Conversely, the payment of principal on loans is a use of cash or an outflow.
Capital purchases are also a typical use of cash. Buying equipment will not show up as an expense on the Profit and Loss Statement but will increase capital on the Balance Sheet.
To determine your company’s ending cash balance (overall or net change):
Beginning Cash Balance + Cash Inflows – Cash Outflows = Ending Cash Balance
With an understanding of the appropriate format for your company’s financials and the three key financial statements (Balance Sheet, Profit and Loss Statement and Cash Flow Statement) under your belt, you’re well on your way to understanding your business’s financial picture much better.
That said, having a good financial picture of your business is not just academic, it’s about the literal survival of your company.
Let’s end with two case studies that snap this fact into focus:
Case Study #1: Can a Company Showing a Profit be losing money?
We recently worked with a healthcare company that had several financial entities. The company’s Profit and Loss Statement showed a good profit, but cash was very tight and no one understood why.
We quickly discovered that one culprit was the complexity of the company’s reporting structure. It simply didn’t allow leadership to view a consolidated picture of the company’s entities.
In fact, the owner was only looking at the Profit and Loss Statement and not the Balance Sheet or the Cash Flow Statement.
An analysis of the consolidated entities revealed significant outflows of cash on the Balance Sheet. Specifically, distributions to outside entities and partners – which are all uses of cash, and which all had gone unseen by leadership.
The reality was that the cash outflows exceeded profit – the company was not profitable at all, and was also not sustainable under the current scenario.
To solve the problem, we developed a financial forecast that included the Balance Sheet actions of the company and advised on serious changes that needed to be made immediately to shore up profitability and cash flow overall.
Case Study #2: Can the Basis You Use for Accounting Make that Much of a Difference?
A project management firm was having cash flow problems, even though the owner believed the company had a strong margin.
Our preliminary analysis revealed that the firm’s controller was “managing” payments to vendors based on who made the most noise. There were also many unrecorded liabilities, including sales taxes, commissions and more. Further, the company was not looking at its financials on an accrual basis – a huge problem if you want to understand a company’s financial health. Here’s why:
Under cash basis accounting, revenues are reported in the period cash is received and expenses are reported when cash is paid out. Accrual basis accounting reports revenues when they are earned – which often occurs before the cash is received – and reports expenses in the period they either occur or expire – which often happens in a different period than when they are actually paid.
This means that under the accrual basis, all revenues actually earned during the period and all expenses required to earn those revenues are seen at the same time.
When I worked with the company to recast its financials in accrual basis, I uncovered that it had far more liabilities than assets.
We were looking at far more than a cash flow problem. The company was actually in a full-scale turnaround situation.
The morale of these stories: Things aren’t always as they seem, and having a clear financial picture is the only way to ensure your company is profitable and sustainable.
But this is only the beginning of the road to full clarity.
In part two, we’ll look at basic financial KPIs or Key Performance Indicators that will help you dive deeper in determining how well your company is actually doing.
I decided to write this in-depth article on financial basics because I’ve noticed that my Growth Advisor clients benefit deeply from gaining this understanding early on in our work together. In fact, sometimes, I’m brought in as a Growth Advisor to simply cover these basics and help a CEO gain the financial knowledge he or she needs to move forward more wisely.