Understanding The Big Three Financial Statements: Profit and Loss, Balance Sheet & Cash Flow

How often and how closely you analyze your financial statements says a lot about how you management your business.  Too often business owners take the financial statements prepared by their accountants and drop them in a desk drawer or file folder as soon as the accountant leaves their office.  Why?  Because most business owners are not accountants and many don’t really understand these statements.  This is a shame because they fail to utilize one of the best resources for managing their business.  If this sounds like you, don’t worry it’s not all your fault.  Some of the blame lies with your accountant.  He or she should have made sure that you know how to read your financial statements, know how to look for trends in them, know how to monitor your receivables and payables, and know how to track labor and materials to sales.  This article will not provide you with all the knowledge you need to best utilize the power of your financial statements, but it is a good start.

The Profit and Loss Statement

At the end of the month, your company or your accountant should generate a Profit and Loss Statement.  Understanding your profit and loss statement is the key to improving your profits.  Most of the answers you need to improve your bottom line are found here or in the detail that makes up this statement.  It is important to generate these statements monthly because the sooner you discover problem areas the sooner you can take corrective action.

The following is a very simple profit and loss statement.

    For the Month of January, 2004

          Gross sales                $15,000

          Less returns                       650

          Net sales                  14,350

        Cost of goods sold

          Products                  7,200

          Direct labor                  1,100

        Gross profit                  6,050

        Less general & administrative expense

          Salaries                  1,500

          Rent                         600

          Interest                     375

          Utilities                     195

          Telephone                     250

          Freight/postage                   66

          Office supplies                   70

          Advertisement & promotions          350

          Miscellaneous                  240

        Total expenses                   3,952

        Net (before tax) profit             $2,098

In this example, all sales are grouped together but if you want to track different sources of income (revenue), you may segregate the income account (gross sales).  The point of this would be to determine if one type of product or service sales are going up and another going down.  This would allow you to reduce purchases of slow moving inventory and run promotions to increase activity.  The same theory of segregation also applies to each line of the profit and loss statement.  Be sure only to segregate what you can measure and manage.

On the direct expense side, you have the chance to discover where your profit is by costing merchandise directly against the sale.  For example:

    Wood Fence Sales        $2,500

        Product cost          1,500

        Difference          1,000

    Iron Fence Sales        $2,000

        Product cost             800

        Difference          1,200

What this tells you is that the profit margin is higher on iron fences than on wood fences, so it is in your interest to inventory, advertise, and promote iron fences. 

Your expense detail can tell you a great deal if you create enough categories.  One critical example is salaries.  As your business grows and you take on more people, you soon have officer salaries, managerial salaries and office or administrative support salaries.  By identifying these separately with costs as a percentage of total sales, you can know when overstaffing has become an issue or when funds are available for additional hires.

Each item of your profit and loss statement should also have a percentage (%) number attached as well as a dollar value.  This is important because the key to profitability is to focus on budgets as to what profit margins must be maintained at and what expenses must be controlled.  The use of percentages is also useful in period-to-period comparisons.  If your volume varies by season, the only way to identify the outcome is to see how the percentages of profits and expenses change from period to period.  This also helps establish budgets for a particular season.

Great.  You know how your company did but how good is that?  Are you ahead or behind other companies like yours?  Most industries have information on normal industry expected performances against which you can compare your financial performance to those of your peers.  Robert Morris Associates is a national organization that collects benchmark numbers based on the financial statements provided to bankers across the country.  If your industry association or accountant doesn’t have access to national benchmark information, Robert Morris is a good starting point of comparison.  When comparing to others, you should look at direct costs comparisons including labor and material costs (percentage of revenue), gross profit margins, costs of employee benefits, occupancy costs and interest paid.  You may want to consider other key performance indicators but these are standards.

One final thought on the profit and loss statement.  Work with your accountant to change your chart of accounts and create lines items to better manage your business.  Hidden costs and problems can drain profitability if not discovered, measured and controlled.

The Balance Sheet
Second only to your profit and loss statement, as a barometer of the health of your business is the balance sheet.  The balance sheet is made up of a listing of your assets and liabilities.  For example:

    Assets

        Current Assets

            Cash in bank                        $2,500.00

            Accounts receivable                         650.00

            Notes payable – short term                     .200.00

            Inventory                         35,000.00

            Total current assets                     38,350.00

        Fixed Assets

            Leasehold improvements                 10,000.00

            Machinery and equipment                   6,000.00

               Less depreciation (for both)                   2,000.00

               Net book value                       4,000.00

            Long-term notes – net value                   4,000.00

            Total fixed assets                     18,000.00

        Total assets                            $56,350.00

    Liabilities

        Current liabilities

            Accounts payable                    $15,000.00

            Payroll taxes due                        1,150.00

            Loans due (current portion)                    2,165.00

            Total current liabilities                  18,315.00

 

        Long-term liabilities

            Long-term portion of loans or notes              15,000.00

        

        Total liabilities                        $33,915.00

    Shareholder equity (net worth)                     22,435.00

    Total Liabilities and Shareholder Equity                $56,350.00

If you own the building and land in the company (not always the wisest strategy), they would be valued at their cost value first, then any depreciation already taken in previous years would be deducted and the net book value is carried on the balance sheet.  I’ll discuss this idea in more depth later in the article.

The balance sheet is a good tool to measure the solvency of your company (meaning it is likely that your business can pay employees, creditors and lenders in a timely fashion).  If you have more current assets than current liabilities, your solvency may be adequate.  If even, you may not have the resources to retire debt and if your current liabilities are more than your current assets, you are most likely facing a cash flow problem.

The last item on a balance sheet is called shareholder equity or net worth but that is misleading.  This is the “book value” (including depreciation) on your tangible net worth.  The values here are all tangible property.  The actual value of your company may be higher or lower.  For example, you may have equipment that is still valuable if sold although it has been fully depreciated on your books and therefore shows no value on your balance sheet.  You may also have intangible assets such as a good brand name that may be valuable.  On the other hand, if your inventory has become obsolete and it is still on your books, the value of your business may be less.  If you want a truer value of your business (say for a buy/sell agreement between you and your business partner), hire a Certified Valuation Analyst (CVA) to conduct a business valuation.  As a going concern, the value of your business is more based upon the future earnings potential expressed as a multiple of the current earnings than the value on your balance sheet.  But don’t confuse the balance sheet value or the CVA’s value with market value.  If nothing else, the online auction web site, Ebay, has taught us that the value of something is whatever someone is willing to pay for it.

Perhaps the most important internal use of your balance sheet is to monitor any changes in net value or solvency from one period to another.  Are you building equity in the company or draining the value of your assets to keep the business going?  A business is measured by its progress, which is increasing revenues with increasing profits and a strong balance sheet.

Cash Flow Statements
Cash is king!  And cash and profits are not the same thing.  A company can have good cash flow but still be losing money.  Every business owner needs to have an understanding of the cash requirements of his or her business so that he can plan for the availability of capital when needed.  Why is cash so important?  Positive cash flows in and out of a business is a critical measure of how it is performing currently and a predictor of how it is likely to perform in the future.

Over the life of a business there are three periods when cash is critical.  The first is at start-up when cash is needed to invest in establishing the business, investing in equipment and machinery and otherwise furnishing the company with what it needs to conduct business.  Ongoing businesses need capital for purchases of assets, repayment of debt, repurchase or redemption of equity and funding losses.  Growth demands cash.  Cash is required for increasing levels of inventory and the purchase of buildings, land, machinery and equipment to support higher sales.  Growth creates a shortage in cash flow even when operating funds are profitable. 

So, if cash is so important can cash flows be predicted? Yes.  It is possible to predict the flows of cash through a company on a month-by-month basis for up to a year in advance with some accuracy.  A cash flow projection starts with the profit and loss statement because the primary source of capital in a business is the operating funds.  A cash flow statement typically looks like this:

                       May           June           July

    Sales income            $20,000    $22,000    $21,000

    Direct expense              11,000      12,100      11,550

    Gross profit                9,000        9,900        9,450

    Overhead exp                7,200        7,200        7,200

    Net profit before taxes        1,800        2,700        2,250

    Starting cash                6,500        4.600        2,600

    + collections              15,000      18,000      19,000

    Total available              23,500      22,600      21,200

    Less direct              11,000      12,100      11,550

    Less debt payment               900           900           900

    Ending cash              $4,600      $2,600      $1,350

Several important items to remember: 1) depreciation is a noncash item and is not deducted from a cash flow statement, 2) the principal payment (debt service) must be included in the cash flow, 3) all income (revenues) does not turn into cash immediately.

How much cash you need varies greatly from business to business and depends a good deal on your sales credit policies.  Growth in revenues is desired but without significant capital to fuel the growth, you may have some troubles.  The cash flow statement is an important document to help you determine when a cash crunch is coming and to assist you in determining how much money you will need as a working capital loan.

If your accountant has taken the time to ensure that you understand how to use these important management tools, then you probably have a good accountant.  Keep him or her.  If you accountant hasn’t taken the time but is willing to, you may be able to salvage your accountant.  But if he or she won’t, can’t or if you feel they are unable (to the degree you want), you need a new accountant.