Today’s post is a remake of one of my most popular old posts: the 5 minute finance lesson covering the basics of understanding your financial statements.
If this is your first time here at New Venture Mentor, be sure to subscribe to the email list using the box in the right sidebar to join the thousands of entrepreneurs I’ve helped to launch and grow their businesses and be the first to know every time I add a new post.
One of the biggest issues I see with entrepreneurs – no matter how big or small their business – is that they don’t have a grasp of their financials. If you don’t have an accountant, you clearly need to have at least a basic grasp of how to manage your business’ financial health. If you do have an accountant, you need to understand what she gives you and be able to have an informed conversation with her about your business’ financial performance and where improvements need to be made.
Is all of that going to happen in a 5 minute finance lesson, obviously not; but at least you can get a basic understanding of the 3 main financial statements – the balance sheet, income statement, and statement of cash flows – and what each means for understanding your business.
The first financial statement that you’ll need to know about is the balance sheet. The balance sheet shows a company’s assets, liabilities, and shareholders’ equity as of a specific date. Its assets are split into current assets, which includes liquid assets such as cash and accounts receivable and property, plant, and equipment, which are less liquid assets such as land, buildings, and obviously equipment. Liabilities are also split into current liabilities and long-term liabilities. Current liabilities are those due within the next year while long-term liabilities are those due in over a year. So, for example, if you have a mortgage, the portion of the mortgage that’s due within the next 12 months would be counted under current liabilities and the rest of that mortgage would be counted under long-term liabilities. The total assets and total liabilities plus shareholders’ equity must equal each other, so if you create a balance sheet and these two numbers don’t match, you’ve made a mistake somewhere and need to go back and check your work.
The second financial statement that you’ll need to learn is the income statement, also known as the profit and loss statement. The income statement shows a company’s profit or loss over a specified period of time and it shows revenue and expenses split into operating and non-operating income. Operating income starts with sales and cost of goods sold to give the gross profit margin. It then deducts operating expenses, split into selling expenses and general and administrative expenses. Selling expenses are those expenses directly related to sales and would include things like sales commissions for your salespeople. Administrative expenses include the costs of running the business that are not directly related to sales, such as office supplies and utilities. The gross profit minus your operating expenses gives you your operating income and then you add or subtract the non-operating income, such as interest, to get your net income.
The final financial statement that you’ll need to learn is the statement of cash flows. The statement of cash flows is vitally important as many small businesses fail not because of profitability issues but because of flow issues. The statement of cash flows shows a company’s inflow and outflow of cash over a specified period of time. The cash flow statement is broken into cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. For cash flows from operating activities, you start with the net income and then you adjust for non-cash revenue and expenses such as depreciation, accounts receivable, and accounts payable. For cash flows from investing activities you include things like the sale of a factory, building, or equipment. And finally, for cash flows from financing activities, you’ll include things like the sale or purchase of stock or a distribution of dividends. This gives you your net increase in cash. Add that to the cash you had at the beginning of the period and you’ll know how much cash you have on hand and available now.
Now that you understand the very basics of these three financial statements, you’ll better understand how your company is performing so that you can strategize for future growth. If you need a bit more info, which you will, I have some old-school New Venture Mentor videos linked to below that will give a bit more background on each of these three financial statements separately: