You’re not expected to know everything in your small business. Maybe you’ll never understand the ever-changing tax code or how the cloud works, but that’s okay. As long as you know who to go to for information and with an interest in learning, you will be successful. When it comes to your small business financial statements however, there are a few things you DO need to understand. In this blog we’ll break down the most important aspects of your small business financial statements, what they mean and what to look for.
Let’s break it down into parts, or which reports you should be reviewing weekly, or monthly (depending on your type of business.)
- What is it? A balance sheet is also called a statement of financial position. It shows you at a glance your assets, liabilities, and equity. Think of it as a snapshot of your business finances.
- Why is it important? The balance sheet shows one measure of what your business is worth (the value). This can be important for lenders, to see if your business is “worth the risk” of a loan. For businesses with investors or for C-Corps, it shows your value.
- What is the formula? Assets = Liabilities + Equity
- What is it? Also called a profit and loss statement, the income statement shows your revenue (money coming in from sales or accounts) -vs- expenses or losses (money going out for bills, taxes or losses on sales.)
- Why is it important? Income statements helps you, the small business owner, decide if you can make a profit by increasing revenues, by decreasing costs, or both. The income statement shows you if the strategies you have in place are working and if you are making a profit.
- What is the formula? Revenues – Expenses = Profit or Net Income
What is the difference between a balance sheet and an income statement?
Think of the balance sheet as the “bigger picture”. It shows a snapshot in time of one measure of the overall value of your entire business. The income statement is a smaller snapshot of operations for a small bit of time and if you are making money based on your sales, once the expenses are subtracted.
Cash Flow Statement
- What is it? Think of the small business cash flow statement as a river. It is the flow of money in and out of the business.
- Why is it important? The cash flow statement shows the amount of liquidity (or ability) for a business to pay its bills.
- What is it used for? Cash flow statements can help you, the business owner, budget and predict future cash flows.
- What is the formula? There are different types of cash flow statements and each have a different formula and purpose:
- Cash Flow = Cash from operating activities +/- cash from investing activities +/- cash from financing activities + beginning cash balance.
- Free Cash Flow (takes into consideration your depreciation and working capital: Free cash flow = Net income + Depreciation/amortization – change in working capital – capital expenditure
- Operating Cash Flow = Operating income + depreciation – taxes + changes in working capital
What does “Cash -vs- Accrual” mean?
It’s important to know (especially for tax returns) if your method of accounting is “Cash” or “Accrual” here is the difference:
- Cash Accounting: Business transactions are shown on your financial statements when cash comes in or out of the business.
- Accrual Accounting: Revenue is recognized (or put on the income statement) when the revenue is earned. Expenses are recognized when they occur, regardless of when actual money changes hands.
Let’s say you own a small business that sells lawn mowers. If you sell $3,000 worth of lawn mowers to Jim’s Mowing Company, under the cash method, that amount is not recorded in the books until Jim hands you the money or you receive the check. Under the accrual method, the $3,000 is recorded as revenue immediately when the sale is made, even if you receive the money a few days or weeks later.
The same principle applies to expenses. If you receive an electric bill for $1,200, under the cash method, the amount is not added to the books until you pay the bill. However, under the accrual method, the $1,200 is recorded as an expense the day you receive the bill.
It can appear very similar, however the exact timing for when revenue and expenses hit your books (especially if it occurs over different tax years) can directly affect the taxes you pay.
What else do I need to know about my financial statements?
You or a bookkeeper are responsible for the information that is logged into financial software. Some things to double check include:
- Make sure expenses are categorized uniformly: In other words, if you create an “office supplies” expense, make sure you only log true office supplies in that category. You don’t want to switch categories mid-year and start calling them “misc. expense”
- Focus on Cash Flow: It’s important to know where your money is, when it’s coming in and where it’s going.
- Project and plan for needs: Pay attention to your balance sheet and income statement. This can help you plan for new projects, future expansions or hiring more help.
- Look at trends: Was April your busiest month last year, or was it July? Look for trends and adjust as necessary. Maybe you can reduce staff in the winter and hire more people in the summer.
Understanding your own financial statements and knowing what to look for can help you see problems sooner. You’ll be better able to manage cashflow to invest or manage borrowing needs.
For additional resources on how to understand your small business’s financial reports, what to look for and how to spot trends, please contact us at the Small Business Development Center – SBDC – serving Collin and Rockwall Counties, Texas.
Blog post by: Alex Plotkin