If doctors check the pulse of patients to know the state of their health, business owners have only their financial statements to bank on. These reports will tell you all that you want to know as a small business owner – how much you owe your vendors, how much is due from your customers, profitability, cash flow, and working capital requirements.
It will also tell you whether you have enough surpluses to go for expansion and diversification. However, while the importance of financial reports cannot be denied, they can only help you if you know how to read between the figures, analyze them well and know their several implications.
Any business will have a large number of primary and secondary reports that will be generated. The main ones are income and expenses report more commonly known as the profit and loss statement and the balance sheet. Others individually support these two like the accounts payable and receivable statements or the fixed assets statement and their consolidated figures reflect in one of the main two reports.
This article will be a guide to reading and understanding financial statements which small business owners especially those in the initial stages of their launch will find particularly useful.
But first, it is necessary to know why it is so important to understand your financial reports at all especially with regard to the P&L and balance sheets. P&L gives you a clear picture of whether you have created a surplus or incurred losses over a period of time which is usually one month.
A balance sheet gives you an overall view of the position of your business at the end of the month. While making crucial decisions you should not look at the two in isolation. Here are the reasons why to get true benefits, you have to take both into account.
- Reason 1 – If you look at any one – P&L or balance sheet – you will not be able to make smart business decisions. Your balance sheet might show that your overall business is making money but if your P&L shows that you have made losses for the month you should refrain from making any expansion plans for the present. Analyzing both simultaneously will only give you the true position. If you hire professional accounting services, they will optimally guide you on the actual state of your financials.
- Reason 2 – Both the financial reports give an estimate of what you owe in taxes. The common misconception is that business owners have to pay taxes on what they draw from their venture or the owner’s distribution. In reality, IRS norms stipulate that you will be taxed on your surplus that is the net income. If you are running in loss, regardless of what you take out, you are not liable to pay taxes. Hence, to arrive at the quantum of taxes payable your accounting solutions should include analyzing P&L to determine if you have a net profit or loss.
Coming to the main issue now, how do you read and understand your main financial statements? Building both P&L and balance sheet requires various inputs which accounting services will extract from your bank statements. There will be many expense heads such as marketing costs, business equipment, supplies, loan payments and auto expenses for example.
Income is based mainly on customer payments. It is here that expert accounting solutions will determine which components of the bank statements will go into the balance sheet and which in P&L account.
Analyzing Profit & Loss Statement
A Profit and Loss statement shows all income, costs, and expenses over a fixed period of time generally over one month. However, out of total inward flow, some will be entered here and some directly on the balance sheet.
For example, customer payments are income and will be in P&L but loans even though they are incoming amounts are the liability and hence will be on the balance sheet.
Similarly, for expenses, cost of goods is what you spend on producing your goods and services but will not be in any P&L head even though you will want to know the quantum of this spend. It will be on the balance sheet.
The monthly business expense will include marketing costs, auto expenses, rents paid and food and entertainment. But business equipment and owner’s distribution will be in balance sheet only.
The next step is to work out the income from various sources, mainly customer payments. The two-total income and total expenses – will be then arrived at to see if your business has made a net gain or net loss for the month. Your P&L statement will not reflect the amount in your bank from surpluses or losses; it will simply tell you whether your outflow has been more than your inflow or vice versa.
Analyzing Balance Sheet
A balance sheet is a breakdown of your assets, liabilities, and equity and is a glimpse of where your business stands with regard to the three.
The asset section lists out your physical assets such as plant and machinery and buildings, computers and related equipment and any other purchases. These are known as fixed assets. Your variable assets are your receivables or amounts that are due to you from vendors. These two will be added to the cash on hand of your business to arrive at the total assets figure.
The liabilities part is what your business owes to others. Loans and advances have taken from banks or financial institutions, credit cards, auto loans and what you owe to your suppliers and vendors are all considered to be your business liability.
Equity component in the balance sheet is a complex issue. It consists of two components. The first is the owner’s distribution or what you have paid yourself that month. Next, are retained earnings or surplus. The excess of income over expenses (profit) is added to previously retained earnings or any loss (excess of expenses over earnings) is subtracted from that to arrive at the current net retained earnings.
The total liabilities and equity are then added together and this amount should be equal to the total of your assets. Only then will you know that your balance sheet is correct in all respects.
It is now easy to understand why as a business owner you should master the concept behind P&L, balance sheet statements, and accounts payable. These three are the indicators of operational efficiencies and health of your business and thus should be scrupulously monitored.
If you feel that you should get professional help in this regard, entrust the work of generating and analyzing these two key statements on a turnkey basis to experts in this field.
Alika Cooper is an independent business consultant, specializing in technology, social media trends, and entrepreneurship. She is contributing her skills, knowledge, and experience to assist people pertaining to finance and accounting matters.