Understanding the Essentials of Your Small Business Financials (Part 2)

Published by BradyRenner CPAs | April 3, 2017

In the world of small business, entrepreneurs are responsible for learning and knowing something about every aspect of their business. From marketing and product management to customer service, technology and accounting, as a small business owner it’s imperative that you know enough about each aspect of the enterprise to supervise and ensure its success.

One of the essential functions that every small business owner needs to understand is core financials. Short of having a full-time CFO on your executive team (or partnering with a fractional, outsourced CFO to provide these services), it’s critical for you as the business owner to stay on top of the numbers.

Perhaps the easiest way to begin understanding this area of your business is to focus on two components: key numbers, and essential reports. The first article in this series focuses on numbers (also referred to commonly as metrics or indicators), and the second one focuses on reports.

In this, the second article in the series, we’re going to take a look at five essential financial reports (also referred to as financial statements) that you should know, read and respond to every day in your small business:

1. Balance Sheet

The balance sheet (also known in the accounting industry as the Statement of Financial Condition) is the first of the ‘big three’ reports that every business owner should review regularly and know inside and out. The balance sheet provides a snapshot of the overall financial state of the enterprise. The balance sheet report is based on an equation, which is:

Liabilities + Owner’s Equity = Assets

This is a balancing equation (based on the concepts of double-entry accounting), so the two sides must balance out. On one side will be current assets (those that represent cash and cash equivalents) as well as fixed assets (such as furniture, equipment, land, buildings and machinery). On the other side will be short-term liabilities (generally accounts payable and taxes), as well as long-term debt (such as bank loans or notes payable to shareholders or members).

A balance sheet report will often be presented in two columns, with assets listed on the left and liabilities, as well as owner’s equity, on the right. Alternately, the report will be presented in a single column, but where the assets are presented first.

2. Cash Flow Statement

The cash flow statement (or statement of cash flows) is the second of the ‘big three’ reports. This statement tracks the inflows and outflows of cash that result from the company’s activities, including operations, investments and financing activities.

In this report, “cash” refers to both actual cash and cash equivalents, which are other assets that can be converted promptly into cash. The cash flow statement helps you know how healthy your business is, and in particular, how much liquidity (the ability to promptly produce cash to pay for any costs or expenses), the company is maintaining. The cash flow statement is also valuable for comparing performance over time to identify factors driving change.

3. Profit & Loss Statement (P&L)

The profit and loss statement (also referred to as the P&L or or as the Income Statement), provides the ability to project sales and expenses, and is often examined over a span of a month, quarter or year. This report is based on the equation:

Gross Margin – Total Operating Expenses = Net Margin

As we discussed in the first article from this series, gross margin (or gross profit) is the total sales minus the Cost of Goods Sold (COGS). This figure (COGS) includes factors such as raw materials, inventory costs, payroll taxes, etc. Then, to determine net margin (or net profit), also factor in overhead considerations like utilities, rent or mortgage costs, maintenance and repairs, insurance and legal costs as well.

Typically, the Profit & Loss Statement will be produced as a multi-column report where each column represents a period (generally one month), and the numbers are presented for each of the reported months in the order:

  • Revenue
  • Cost of Goods Sold
  • Gross Margin/Profit
  • Variable Expenses
  • Fixed Expenses
  • Net Operating Income
  • Other Income
  • Net Margin/Profit (or Loss)
  • Net Margin/Profit after Taxes

4. Inventory Report (for product companies)

If your business produces or distributes physical products, then your next critical report (after the ‘big three’) should be the inventory report. This report is designed to present information on the products you carry (organized by product categories or other key factors), and then help you evaluate things such as:

  • Current quantity on-hand
  • Sales value of quantity on-hand
  • Quantity sold in the last period
  • Sales price / cost / gross profit / gross profit percentage
  • Average number of units sold per period
  • Average number of days of inventory held
  • Inventory carrying cost of quantity on-hand

This allows you to compare current inventory levels with the past, as well as observing trends in turnover. This, when combined with the information on the days of inventory held (based on current sales figures) and the carrying cost of the quantity you have on hand, will give you a clear picture of where you’re saving or losing money due to uneven inventory planning, purchasing and management.

5. Utilization Report (for service companies)

If your business doesn’t produce or distribute products and instead primarily delivers and is paid for providing services, then the utilization report is your next go-to. In the services industry, utilization is identified as the amount of hours a given resource (typically a person, team or job tier or title) bills vs. the amount of hours it works.

Typically, this is useful when we’re working with primarily salaried professionals who are tracked against a billable activity standard (often between 65% and 85% depending upon the industry). For example, if a person charges 30 hours of billable work in a 40 hour work week, their utilization was 75%.

More sophisticated reports can also address realization, which adds in the actual revenue billed against the resource’s utilization. For example, the same resource may be billed at $100 per hour on one project or client engagement, and at $125 per hour on another engagement.

This may be due to actual differences in billing rates that clients agreed to, or it may be due to the difference between actual billing (when a client always pays for the actual hours being spent on their work), and a retainer-based or flat-fee scenario, when the client pays the same amount each month even if the amount of work goes up or down (and, as a result, the effective billing rate may change accordingly).

The utilization and realization reports allow those in the services sector to analyze operations in their talent-centric businesses with a degree of precision similar to their colleagues in product-focused enterprises.

Know Your Numbers…And Read Your Reports

In the first article in this series, we emphasized the importance of knowing your numbers. The best way to know those numbers is to incorporate and calculate them through proper financial statements and reports that you review on a regular basis.

By committing to the discipline of weekly, monthly, quarterly and annual financial review of both, you’re going to be extremely well-positioned to weather market changes, predict future openings or opportunities, respond to changing operating conditions, and build a truly sustainable small business.

Image Credit: Philippe Put (Flickr @ Creative Commons)