Handy Guide to Small Business Financial Statements
Having solid numbers that you can trust is the first essential step in having Meaningful Money. That’s why we recently, wrote about having accurate financial reports and building trust with those numbers.
Can I trust the Numbers in My Business give you the step by step process to make sure you have clean numbers and can keep them that way.
Now that we have that figured out — it’s time to talk about what the numbers can actually tell you. You can think of this as Part 1 of your Handy guide to small business financial statements.
In this post, we’ll show you the key things you need to look at in your financial reports so that you can make the best decisions in your business this year.
There are 3 Essential Financial Reports for Every Business
There are many, MANY financial reports you could use in your business, but there are three that are essential for EVERY business. In fact, all other financial reports you can pull from your bookkeeping system are essentially deep dives into various parts of these three reports.
Income Statement (or Statement of Profit and Loss) tells you how profitable your company is over a specific time period — for example, a month, quarter, or year.
Balance Sheet is where you find the value and financial sustainability of your company at a specific moment in time. Think of it as a snapshot.
Statement of Cash Flows shows you how and where money comes in and goes out of your business within a specific time period.
There are probably thousands of blog posts out there that go deep into the accounting definitions of these reports. But the important thing for most business owners is understanding what these financial reports are telling you and then using them in your decision-making.
Naturally, that’s what we’ll focus on.
How to identify critical information in your financial reports.
When you look at your financial reports, start by focusing on the most important information you need to make good decisions for your company. For most business owners, the top three concerns are:
Profitability
Cash flow
Financial stability
For the remainder of this post, well walk through simple ways you can find useful information about each of these in your financial reports so you can use your financial reports to inform your decisions.
Just remember, you can always go deeper and get the financial knowledge you need with Money Essentials.
Keep an Eye on Your Business Profits
If you’ve been in business for more than a minute you already understand why profit is important. Without profit, your business can’t survive.
Profitability simply means the extent to which the company is able to bring in more revenue than it spends on operations.
But how much profit is enough? And is your profit growing or shrinking?
The income statement reflects your company's revenue and expenses and shows whether the company is generating a profit — or a loss.
Key ratios that can help you evaluate profitability include:
Gross profit - the amount you earned on each item or service sold after subtracting the specific costs of that product or service
Net profit - how profitable is your business after paying all your expenses
You can find this information on your Income Statement or Statement of Profit and Loss.
Simple math:
To calculate the Gross Profit Margin (or % of revenue remaining after paying for all your costs of goods): take the gross profit and divide it by total revenue.
To calculate the Net Profit Margin (or % of revenue retained as profit): take the Net profit and divide it by the total revenue.
A number or even a percentage doesn’t tell you very much all by itself. Numbers need context to help you see what’s going on. So once you have calculated your gross margin and net profit margin, compare this month’s profitability to your budget or forecast, then to last month, and then to last year at the same time.
Comparing your current financial results to a previous time helps you see trends and figure out if profitability is moving in the right direction and how quickly.
Comparing to a budget or forecast will let you know if the business is going to meet its targets or if you have to make changes in your sales strategy, advertising budget or operating plan to make up the difference.
Monitor Cash Flow in your Business
Cash flow is the movement of money into and out of your company. It is another key concern for small business owners because, as we all know by now, cash is queen!
By looking at your Statement of Cash Flows, you can track how cash is coming in and going out and ensure that there is sufficient cash available to pay for everything you need.
You can also look at key ratios based on your Balance Sheet to evaluate cash flow:
Cash conversion cycle - which literally calculates the number of days (on average) that it takes for your company to convert its investments in products or inventory into cash from sales.
Current ratio - This compares your cash and accounts receivables to your bills and short-term debts. The Current ratio is shown as two numbers — 2:1 current ratio means you have twice as much in short term assets as you owe in short term liabilities. This would be a pretty healthy cash balance for most businesses.
Of course, with each of these numbers you also want to compare your current results to both what your expectation is (from your budget or forecast) and to prior months or years of experience.
If your cash conversion cycle is getting longer — because of shipping delays or slower sales, — you’ll need more cash on hand to manage the business.
If your current ratio dips below 1:1 this means you don’t have the cash in your bank accounts plus recent sales to pay the bills that are due. Huge red flag! 🚩
Check Overall Financial Stability and Value of your Business
Naturally, another priority for business owners is being financially stable — especially during unstable times in our economy like the current (not quite) recession.
Financial stability shows up on your financial reports in a few ways.
One simple thing to look at the total amount of cash in your business.
The bottom line of your Statement of Cash Flows shows the net cash for the period – This indicates whether your cash on hand (the sum of all your bank account balances) is growing or shrinking each month.
Then you can look at the detail on the Statement of Cash Flows to see if this change (up or down) is coming from your operations or from investing and financing activities like loans coming in or loan payments going out.
If you are operating profitably, but have large loan payments that you need to make, you could have a healthy cash profit, but be draining cash out of the business through financing activities which could make it harder to continue.
Other Key ratios that can help you evaluate financial stability also relate to whether the business include:
Debt-to-equity ratio - which measures the amount of debt the company has relative to its equity
Interest coverage ratio - which measures the company's ability to pay its interest expenses
And by keeping an eye on these key metrics, you can make informed decisions about loans or financing that can help your business thrive.
Ready for More Help Using Your Financial Reports?
If you want to really get to know and understand your financial reports, Join Meaningful Money Essentials and work alongside other business owners to step up your finances in 2023!
In 3 short weeks, this course will give you the skills you need to understand your business finances and gain control of your cash flow.
You'll learn from 2 finance professionals who have worked with over 100 companies on accounting, coaching, and business growth. In the course, you'll gain three essential skills:
Use our checklist and training to review your bookkeeping to make sure it is all solid.
Learn to understand and question your financial reports so they can make sense forever after.
Create and use a 13-week cash plan that works for you and helps you see how your decisions today will affect your bank account next month.
You'll also be among the first to gain access to our community of social-impact business leaders.