Demystifying Financial Statements: What Every Small Business Owner Needs to Know

Today, we’re going to simplify two very important financial statements for your business: The Income Statement (also called the Profit and Loss Statement) and the Balance Sheet. If you’re a small business owner, understanding these can make a huge difference in how you manage and grow your company.

Imagine you’re on a road trip. You wouldn’t set off without a map or GPS, right? The same goes for running your business. Your Income Statement and Balance Sheet are like the map and compass that guide your financial journey. Without them, you might wander a long time and never get to your destination. 

Whether you’re making key business decisions, applying for a loan, or just trying to keep your finances on track, these financial statements are crucial. Think of them as the tools that help you see the big picture and the small details all at once.

We will break down what each statement is, what it includes, and how you can use both of them to your advantage. I promise to keep it simple and straightforward, and use examples that are easy to relate to your business. By the end of this article, you’ll have a clear understanding of these financial statements and how they can help you steer your business towards success.

Income Statement

Alright, let’s dive into the first key financial statement: the Income Statement. Think of it like a report card for your business, showing how well it did over a certain period. Here’s what you need to know:

Revenue

First up, we have Revenues or Sales. This is the total amount of money your business has earned from selling goods or services. Imagine you own a small coffee shop. Every dollar that comes in from selling a cup of coffee, a sandwich, or even a bag of beans adds up to your revenues.

Cost of Goods Sold

Next, we have the Cost of Goods Sold, or COGS. This includes all the direct costs of producing the goods you sell. For our coffee shop, that means the cost of the coffee beans, milk, sugar, and even the wages for the baristas making the coffee. It’s like the money you spend to buy ingredients for a recipe. If you’re making cookies, the flour, sugar, and chocolate chips would be your COGS.

Gross Profit

Now, subtract COGS from your total Revenues, and you get your Gross Profit. This is what’s left over after you’ve covered the basic costs of making your products. Having a healthy Gross Profit Percentage is one of the main keys to building a successful business. It’s like having enough ingredients left after baking cookies to still make a profit. Keep an eye on this number, and if you need to, raise prices to keep it consistent.

Operating Expenses

Then come the Operating Expenses. These are all the other costs of running your business, like payroll, rent, insurance, marketing, and auto expenses. Think of these as the costs to keep your coffee shop doors open, from paying your staff to keeping the lights on.

Net Income

Finally, after you’ve subtracted all your expenses from your revenues, you get your Net Income, or Net Profit. This is the bottom line – what’s left after all expenses are taken out. For many industries, a healthy net profit is about 10% of revenue. If you have a high COGS, check if Net Income is at least 10% of Gross Profit. In some industries, net profit can be 15-20% of revenue. If you want to discuss your net profit percentage more, I’d be happy to talk about that with you.

Application

A great way to use your Income Statement is to compare it to the same period last year. Look at each of the key elements and think about whether it got better or worse and how big the change is.

Keep in mind that due to the timing of deposits and expense payments, cash basis financial statements can fluctuate a lot if you just look at a single month. When you look at a longer period like a quarter or a whole year, you get more meaningful information. Another thing you can do to make comparisons to last year as accurate as possible is to deposit all income and pay your large vendors consistently by the end of the quarter. 

So, that’s the Income Statement in a nutshell. It’s like a financial snapshot, showing you how your business performed over a period of time, and it helps you see where your money is coming from and where it’s going. Keep this report handy, and you’ll have a clear picture of your business’s financial health.

Balance Sheet

Next up, let’s talk about the Balance Sheet. If the Income Statement is like your business’s report card, the Balance Sheet is more like a photo album. It captures a snapshot of your business’s financial position at a specific moment in time, showing what your business owns and owes.

Assets

First, let’s look at Assets. These are everything your business owns. Think of it as your business’s treasure chest. For example, if you own that coffee shop, your assets would include the money in the bank, the coffee machines, inventory like coffee beans, and even the real estate if you own the building. It’s all the valuable stuff your business has.

Liabilities

Next, we have Liabilities. These are what your business owes to others. It’s like your business’s IOUs. This includes things like credit card balances, taxes withheld from employees and customers, vehicle loans, and mortgages. Even money that you, as the owner, invest into the business can often show up as a loan. For our coffee shop, liabilities might include the loan you took out to buy the coffee machines or the mortgage on the building.

Equity

Finally, there’s Equity. This is the net worth of your business, calculated as Assets minus Liabilities. Think of it as the owner’s share of the treasure chest after all the IOUs have been paid off. It’s what you, as the owner, truly own. In our coffee shop example, if your assets total $100,000 and your liabilities are $60,000, your equity would be $40,000.

Application

The Balance Sheet is very important to a bank. Banks won’t loan you more money if you already have a lot of other liabilities (debt). They worry that you will struggle to keep up with all those payments. Banks also want to see that you have some cash on hand (this is part of “Working Capital”) to pay your day-to-day expenses. Sometimes banks will also let you pledge some of your equipment or other assets as collateral for a loan.

So, the Balance Sheet gives you and potential lenders a clear picture of what your business owns and owes at any given time. It’s a critical tool for understanding your business’s financial health and making informed decisions.

That’s the scoop on the Balance Sheet. It helps you keep track of your assets, liabilities, and equity, giving you a clear snapshot of your business’s financial position. Use it to see where you stand financially and to plan your next steps.

What’s the deal with Accrual Basis?

Some items are common on an accrual basis balance sheet, but you won’t see them if your financial statements are on cash basis (this is the same as “tax basis” for most small business owners).

Accounts Receivable (A/R)

First, let’s talk about Accounts Receivable (A/R). This is a fancy term for money that your customers owe you for work you’ve already completed. Imagine you own a landscaping business. You’ve just finished a big project, but you haven’t been paid yet. That unpaid invoice is your Accounts Receivable. On accrual basis financial statements, this gets added to your income because you’ve earned it, even if you haven’t received the cash yet.

For most small business owners, though, you might prefer not to pay tax on income until you actually get the cash in hand. That’s why you won’t see Accounts Receivable on most tax or cash basis financial statements.

Accounts Payable (A/P)

Next, we have Accounts Payable (A/P). This is when your business buys things, typically inventory or materials, that you get to pay the supplier for a little later. Think of it as a short-term loan from your supplier. For example, if you run a construction business and you buy building materials on credit, that’s Accounts Payable.

This isn’t as common as it used to be since many vendors now expect you to pay with cash or card at the moment you place an order. But some contractor supply houses still allow businesses to buy “on account” and pay later. Just like with Accounts Receivable, if you don’t report income you haven’t received, you also can’t deduct expenses you haven’t paid yet on a cash basis.

Application

While there are good reasons to keep Accounts Receivable off your tax basis financial statements, it’s still a great idea to keep an eye on your receivables balance regularly. If you use a software application for invoicing, you can run a report showing your outstanding (unpaid) invoices.

It’s also wise to go through your receivables a couple of times a year to make sure the balances for each customer seem reasonable. If something looks off, you might have forgotten to post a payment or created a duplicate invoice.

By keeping track of these items, you get a fuller picture of your business’s financial health. Even if you prefer to stick with cash basis for taxes, understanding accrual basis concepts can help you make better business decisions and manage your finances more effectively.

Conclusion

So, there you have it. By now, you should have a clearer understanding of the two main financial statements: the Income Statement and the Balance Sheet. These tools are like the dashboard of your car, showing you vital information about your business’s performance and financial health.

The Income Statement helps you see how much money is coming in and going out over a specific period, highlighting your revenues, expenses, and profits. It’s essential for making informed decisions about pricing, cost control, and profitability.

The Balance Sheet, on the other hand, provides a snapshot of what your business owns and owes at any given time. It’s crucial for understanding your overall financial position, ensuring you have enough assets to cover your liabilities, and making it easier to secure loans or investments.

Take a closer look at your own financial statements today and see what they reveal about your business! If you need help, don’t hesitate to reach out to us. We are here to help you make sense of the numbers and use them to your advantage.

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