Financial reports, what are they and why do they matter?
It’s not easy for small businesses to stay on top of their finances.
Each year, the National Federation of Independent Businesses (NFIB) surveys thousands of small businesses on literally everything—including their biggest challenges. Of the top ten challenges in the report, three of them related to financial matters: federal income taxes, tax compliance, and cash flow. A recent study by payment platform WePay reports that 41% of participating businesses struggled with cash flow in the last year.
So what can small businesses do to better manage their financial health without extra resources or time to learn how to be an accountant? The first step lies in pulling together a few simple reports that will create a more clear, actionable picture of the business.
Report #1: The Balance Sheet
Balance sheets illustrate your business’s financial position at a given point in time. The main components of a balance sheet are assets, liabilities, and equity. The essential equation illustrated on a balance sheet is:
Assets = Liability + Equity
A balance sheet is usually set up in a specific order, starting with assets. These are possessions of the company currently, whether or not the company owns them outright. The most liquid assets (like cash and accounts receivable) will be listed first, with additional assets listed in descending order of how easily you can sell them (furniture and property falling towards the bottom).
Next up are liabilities including accounts payable, credit card balances, and loans – anything owed to other entities. Finally, equity illustrates anything the company itself owns. If the owner decided to liquidate the business, selling all assets and paying off all liabilities, equity is what’s left over.
What Should You Look for in a Balance Sheet?
First and foremost: the balance sheet has to be balanced. The total assets must equal the total liabilities + equity or the balance sheet is deemed “unbalanced”.
Because balance sheets are a brief snapshot in time, they don’t demonstrate change. However, they do show another helpful metric: ratios. Here are a few important ones:
QuestionRatioFormulaWhat It MeansHow much liability is there compared to equity?Debt-Equity ratioTotal Liabilities / Total Shareholder EquityHow much of the company is owned versus owed.How much leverage do you have?Debt to Asset Ratio(Short-Term Debt + Long-Term Debt) / Total AssetsPercentage of assets that were financed by debt.What are your current assets minus current liabilities?Working CapitalCurrent Assets – Current LiabilitiesShows if the business can meet obligations.What are your current assets compared to your current liabilities?Current RatioCurrent Assets / Current LiabilitiesHow much the business is bringing in versus paying out.
Report #2: The Income Statement
The income statement provides a clear picture of a business’s income. For a specific period of time, the income statement lists out all revenue and expenses for the company. The result of the income statement is a total calculation of net gain or loss during that period.
The three main areas of the income statement are revenue, cost of sales, and operating expenses. Revenue includes everything you’ve recognized during the time period, regardless of whether or not you’ve received payment. The cost of sales, also referred to as cost of goods sold (COGS), covers all the costs your business incurs to produce and sell products (labor, materials, etc.). Operating expenses are all the other things you spent money on that aren’t considered assets. Think rent, utilities, transaction fees, wages, and marketing expenses.
There are two major calculations off the income statement:
Revenue – Cost of Sales = Gross Income
Gross Income – Operating Expenses = Net Income
What Should You Look for in an Income Statement?
The balance sheet gives businesses a starting point for further investigation. Was your business’s net income positive or negative for the specified period? Did you make money or lose money?
Your best next step is to look at previous income statements to see how things were distributed previously. Are operating expenses consistently higher, or revenue consistently lower? Was there a big hit to the cost of sales in one or more periods? The answers to these questions will help you decide where you might make changes in the business if net income is negative.
Report #3: The Cash Flow Statement
The cash flow of a business is exactly what it sounds like: the movement of cash in and out of a business. A cash flow statement gives small businesses visibility into cash flowing in and out based on a set of categories: operating activities, investing activities, and financing activities.
Operating activities cover inbound cash related to the sale of goods and services, any interest earned, and dividend payments received. Outbound cash covers payroll costs, supplier payments, and monthly bills.
Investing activities include inbound cash from selling business assets and payments received for loans, while outbound would be from things like extending loans.
Financing activities involve all inbound and outbound cash related to the financing of the business. Incoming cash is from the sale of stocks, bonds, and commodities; outbound cash consists of paying back debts and paying out dividends.
What Should You Look for in a Cash Flow Statement?
Cash flow statements give businesses a window into their everyday spending. They demonstrate profitability to outside investors and liquidity to potential creditors. It’s a powerful report for all parties involved. But beyond positive cash flow, what’s there to know?
It’s important to see positive cash flow in the operating activities specifically, as this section represents core business operations. Negative net cash flow in the investing activities area is not necessarily a bad thing, as growing businesses purchase more assets than they sell. Negative net cash flow in the financing activities section is generally considered a higher measure of health, as it’s an indicator that the business is paying off outside debt.Using a balance sheet, income statement, and cash flow statement allows any small businesses to get a clear picture of their financial health. Arena can help you build and maintain these reports for your businesses financial success. Give us a call today.