This article was originally published in YourBiz magazine, you can find the original here.
Cash is the lifeblood of your business – one cannot over emphasise the truth in these simple words.
A good bookkeeper and accountant are essential for recording financial information and keeping you up to date with your financial situation, but the way they do this is to regularly send you a set of financial statements. If you have no idea how to read or use your financial statements, you are not alone. Many small business owners are so focused on daily survival that learning to read financial statements seems like an unnecessary chore. As long as there is cash in the bank, the business is doing fine, right?
Wrong. If you don’t know how much cash you have, have owing to you and owe to other people, then your business is going to end up in deep trouble.
If you do not have the time to do a financial literacy course or in-depth learning, then we urge you to take five minutes to absorb this crash course so that you can, at the very least, see the big picture view of your small business.
There are four basic financial statements that every business owner should recognise and understand:
1. Balance Sheet
2. Income Statement
3. Statement of Shareholder’s Equity
4. Statement of Cash Flows
The Balance Sheet and Income Statement are the two most commonly known and most used by business owners, so those are the two this article will focus on.
The Balance Sheet (also known as a Statement of Financial Position) is a summary of your business’s financial status at a particular moment in time. It shows the values of your assets (items that hold value), the value of your liabilities (amounts you owe) and the value of your personal equity in the business (how much the business is actually worth to you as the shareholder).
The balance sheet does not show a period of time, it shows a moment in time – so you can see the value of your business at the end of the last financial year or you can see the value of your business yesterday. The balance sheet does not show the changes in value over the elapsed time. This is the report you need to pull if you want to know:
- How much money is owed to you (Debtors and Loans made by the company).
- How much money you owe to others (Creditors, Loans made to the company and amounts owed to staff, SARS and other third parties).
- How much physical cash you have (bank balances and cash on hand).
- How much you cash you can theoretically get if you sell everything (book value of your assets).
- How much the business owes to you or how much you owe the business (Director’s Loans, Drawings and Equity).
- If the business is viable (do the assets outweigh the liabilities?).
This report is used to determine the value of a business and the liquidity of a business.
The Income Statement (also known as a Profit & Loss Report) shows the income and expenses for your business during a specified period. You can pull an income statement showing figures for a month, a quarter, an entire year, or the current year to date.
The income statement is split into the following categories:
Income – this section details the different forms of income the company has (retail sales, service income, interest income, rental income, etc.) and how much you have made off each revenue type during the period of the report.
Cost of Sales – these are the expenses that are specifically linked to the production of your product.
A service company will not have a cost of sales section. The cost of sales for a retail company consist of the original purchase price of the product from the wholesaler and the transport costs involved in getting them to your warehouse. A manufacturer on the other hand, can have a far more complicated set of expenses all related to the creation of their product (raw materials, labour, packaging etc).
Gross Profit – this is the Total Income less the Cost of Sales. It is the profit the company has made on its product before any of its running expenses are taken into account. Or, from another perspective, it is the company’s mark-up on its product.
Expenses – this is your easiest section to understand, this is everything you have spent your money on that cannot be classified as an asset or a liability. Here you see how much it costs you to run your business: administration fees, salaries, sales commissions, office expenses etc.
Nett Profit – this is your final profit figure: your gross profit less your expenses. This is the amount your business actually made (or lost) for the report period. This is the figure that your company income taxes will be based on. If this figure is consistently negative its great for taxes and very bad for the future of your business.
You pull an Income Statement when you need to know:
- How much income the business generated in a given period.
- How much profit a business made in a given period.
- Where your money is going, what have you spent it on?
- Is this business actually a viable business?
This report is used to determine risk and stock management factors. Things like your gross profit percentage, sales percentage, mark up, fixed costs, operating costs and commissions are all determined using the income statement.
The balance sheet and income statement are the two most important reports for a small business owner. If you can only learn two financial reports, learn how to read and use these two.
It is important to remember that the information in these reports has been recorded on the “accrual” basis. Very simply, it means that all information is recorded as of the bill or invoice dates – not the payment dates. This means that the profit on your income statement will not necessarily match your bank balance.
As a small business owner you have a responsibility to your business and to yourself to know what is going on with your money. This article covers the basics, but it is highly recommended that you spend some time familiarising yourself with your financial statements: what they are, what they record and what they mean. If you find yourself feeling lost, your accountant should be willing and able to help you make sense of it all!