Finances are like the scorecard that tells you how well your business is performing. But is the thought of business finance like getting a lab report after a doctor’s visit: total confusion, like you are reading Greek?
Let’s dive into the three basic financial statements that make up the backbone of business finances: income statement, balance sheet, and statement of cash flows.
Once you master these, you’ll be able to make better strategic decisions for your growing company. And also make preparing your tax return a little easier.
Income Statement
Have you ever said to someone to “give me the bottom line?” Well, that comes from the first financial statement we will discuss, the Income Statement. Sometimes it may also be referred to as the Profit & Loss Statement or P&L for short.
The P&L shows the business’s revenues and expenses over a given time period. The “bottom line” is when you subtract the expenses from the revenues, leaving what is hopefully a positive number at the end (profit). If the expenses exceed the revenues, the P&L will show a loss for that time period.
What’s on the Income Statement
Let’s start with the good news, right? The “top line” of the income statement is the revenue that the business brings in from business operations. Many companies will have multiple lines, for different types of revenue. For example, at Springboard Legal, the top line revenue would be the fees generated from the fractional general counsel and fractional CFO services, as well as general consulting fees. Each service can have a separate line so that I can see the growth in each service over time.
The revenue is generally followed by the Cost of Goods Sold. COGS are the direct costs attributable to the production of the goods or services sold. For example, in a truck brokerage, COGS would include the cost of the trucks hired to deliver the product from the shipper. Not all companies will track COGS and instead everything will be in the expenses. This is more common in professional service companies like CPA and law firms.
When you subtract the revenue from the COGS, you’ll get the gross profit.
Below the Gross Profit line, you start the expenses. We generally list these by category, starting with items that should be separately stated on the income tax returns (advertising, salaries and wages, payroll taxes, rent are just a few examples) . Additional expense categories and subcategories may be added as needed by the business. However, they should still be categories and not too detailed. A long income statement isn’t going to be useful to anyone.
After all the expenses are added up, you can subtract them from the gross profit to determine the Operating Income.
Below the Operating Income, we will often list extraordinary expenses or one-time expenses. This could be non-deductible expenses like political contributions, or it could opening or closing a new location to account for one-time unusual expenses. It may also include income and expenses that are not from operating activities, like investment income. And everyone’s favorite category: taxes. (Can you feel the sarcasm?)
Then, you are left with the Net Income. This is the bottom line. This is where you tell if the business made a profit or a loss for the period covering the income statement.
Reviewing the Profit and Loss Statement
It is often useful to compare the income statement over multiple time periods. For example, my default view is to look at the P&L on a monthly basis for the past 12 months. This makes it easier to see trends — when expenses in a category are too high or low or revenue is decreasing.
While it seems simple, this is often an early warning indicator that things are not right within the business. This review alone was the first sign that a staff accountant was not paying payroll taxes in a timely manner. For those that don’t know, this is a serious issue that can follow you even if your company goes out of business and it files for bankruptcy. Uncle Sam will always get their payroll taxes. But by catching it early, we were able to resolve it with minimal penalties and interest from the IRS (although it did cost that staff accountant their job).
I’ve also uncovered situations where the business owner was not getting sufficient returns on their marketing spend. Google Ads can be very expensive, especially if you are not bringing in new and additional customers and revenue. By comparing the advertising spend to the new revenue, we are able to keep an eye on the effectiveness and return on investment (ROI) of this expense.
Balance Sheet
While the income statement is the first thing that a business owner looks at, it shouldn’t be the only thing. In fact, the balance sheet can be just as important, if not more so than the income statement. The balance sheet is a snapshot of the financial position of the company.
What’s on the Balance Sheet
The balance sheet is the financial statement that shows the classic accounting formula of Assets = Liabilities + Equity.
The balance sheet begins with the good stuff — the assets. There are two kinds of assets – current assets and long-term assets. The current assets are cash and other short-term assets than can be converted to cash within a year. Think: bank accounts, money market, inventory, and accounts receivable). Then the long-term or non-current assets are more fixed items – loans payable to the company, personal property, and real property.
The next section on the balance sheet is the Liabilities section. Similar to the assets, it will be broken down into current and long-term liabilities. Current liabilities will include things like accounts payable, payroll taxes payable, and short-term loans due. Long-term liabilities can include things such as mortgages and long-term loans.
The equity section is the residual amounts. Usually, companies will track owners’ initial contributions, distributions, retained earnings, and current net income found on the income statement.
Reviewing the Balance Sheet
The balance sheet is important to show the assets and liabilities. If you think of the income statement as showing what did happen, then the balance sheet starts to show the future.
For example, are your current cash and assets enough to satisfy the current liabilities? If not, this is a strategic weakness that needs to be addressed immediately. That may involve a cash infusion by taking on long-term debt or from an owner putting more in.
On the other hand, if the company is accumulating too much in cash or other short-term assets, then maybe the owner can afford to take some money out of the company for their personal goals. Or they can invest in a growth spurt or new product.
But a word of caution — make sure that the short-term asset of accounts receivable is actually turning into cash. While the balance sheet shows AR as close to cash, it is important to ensure that the AR doesn’t become “bad debt” that will leave your company in a world of hurt.
Statement of Cash Flows
The Statement of Cash Flows is probably one of the least utilized financial statement by most business owners. However, it is very useful to show the cash inflows and outflows in a given time period.
Remember how I mentioned that you should watch the AR to make sure that it turns into cash? This is where it will show up, if you let that balance sheet account get out-of-hand. Because you won’t have the cash you need to cover expenses.
What’s on the Statement of Cash Flows
The Statement of Cash Flow is broken down into three sections: operating activities, investing activities, and financing activities.
The operating activities will be the revenues from customers and expenses to vendors and employees. This area will generally track the Operating Income from the Profit and Loss.
The investing activities will be the cash flows from the purchase and sale of assets. So think: factories, office buildings, equipment, and financial investments.
The final section, the financing activities, will be the cash flow from creditors and from owners. This is where you’ll reflect the incoming loan deposits as well as outgoing loan payments of principal and interest. The financing section will also include transactions with the shareholders – contributions to the company, distributions from the company, and loans to and from.
Reviewing the Statement of Cash Flow
Ever heard the saying “cash is king”? If a company doesn’t have adequate cash flows, then it will die. Very quickly. However, if there is enough cash flow to pay the expenses and debts, then things will be good.
But not all cash is equal. For example, most business owners don’t want to have to put more money into the business to pay expenses. They want those expenses to be paid out of the revenue or operating portion of the statement of cash flow.
How to Use the 3 Basic Financial Statements
The three basic financial statements are used as a package deal.
The income statement shows the profitability, which impacts the equity section on the balance sheet.
The balance sheet provides a snapshot of the financial stability at a point in time, so you can see if you are likely to have enough assets to cover liabilities.
The Statement of Cash Flows tracks the actual cash flowing through the company, ensuring that the business has sufficient liquidity and operational continuity for long-term sustainability.
These are the fundamental financial statements that we use to make strategic and informed decisions for your business. They are also used to secure funding from banks or investors and in the preparation of income tax returns. These are the basic building blocks to manage the growth of your business and to navigate challenges as they happen in your company.
Want help creating the processes necessary to create accurate financial statements and then the knowledge to use them to create strategic plans for your business? Then contact Springboard Legal to discuss how Kimberly DeCarrera can be your Fractional CFO.