The simple way any business owner can read financial statements
Too many small business owners don’t review their financial statements monthly. They think they have all the necessary information in their head. But without accurate financial reports, you will never maximize the growth of your company.
It’s essential that every small business owner learns how to read their financial statements. Like so many things in small business, you can’t use your fear or lack of knowledge of numbers as an excuse. Here’s where to start:
Financial statement terms you need to know
A profit and loss statement reports the sales the company made and what it cost to generate that revenue. It lists the revenue, expenses, and profit of a business over a period of time.
The basic components include:
- Revenue: This is a business’s sales, resulting from customers buying your products or services.
- Cost of goods or services (COGS): This is defined as the direct cost of producing sales. COGS can be raw materials, products for reselling, and labor.
- Gross profit: The difference between sales and cost of goods. This is also known as the gross margin. The higher the gross margin, the better.
- General expenses: Types of expenses include things like rent, people, insurance, utilities, telephone, and travel.
- Net profit: Understood as the difference between gross profit and general expenses. The result is how much total profit the company made from its sales. Taxes and depreciation are typically deducted from net profit.
Comparing your previous financial statements will help your analysis of your profit and loss statements. You’ll be able to identify trends when you compare this month’s statement to last month’s or to the same month last year.
Determining what you own and owe
A balance sheet lists the money or other things of value you own and what you owe to others. It also measures the ability of a company to pay its debts. The basic components of a balance sheet are:
Assets: What the company owns. This can include:
- Cash: How much money the company has in the bank
- Accounts receivable: The value and how long the money has been owed to the business
- Inventory: The value of the inventory. This is the price you bought inventory at
- Fixed assets: Examples include equipment, computers, and property purchased
Liabilities: What the company owes. This can include:
- Accounts payable: The money the business owes vendors
- Loans: The money the company owes banks and other sources
Owners’ equity: The assets minus the liabilities. This can include:
- Stock: Paid-in capital to start the company
- Retained earnings: Profit retained in the company since it started
Key metrics to review
One of the most important metrics often missed on financial statements is the “quick ratio” on the balance sheet. The quick ratio, also referred to as an “acid test,” is the business’s current amount of assets divided by current liabilities.
Banks favor the quick ratio metric as it provides a measure of the financial stability of a business and the ability to pay its bills. In most industries, the quick ratio should be greater than 1:1. It shows the company has more cash available than current money it owes. When the quick ratio goes below 1:1, your business may not be able to meet its financial commitments.
There are many good resources available to learn how to read financial statements monthly. Get help from your accountant or bookkeeper, or educate yourself online. Remember, your accountant is an advisor, not an adversary.
The Growth Center does not constitute professional tax or financial advice. You should contact your own tax or financial professional to discuss your situation.