Financial Statements: The Key Reports Every Business Owner Should Know
A, B, C, …
Starting in kindergarten or preschool, you learned the alphabet. From there, you built upon that knowledge and started lining them up to create small words. Words were difficult at first. But soon enough, you knew enough words to start writing simple sentences.
That’s how knowledge grows. In small, bite-sized pieces.
As a kid, I loved reading. The pictures were fun - what an easy trick to get kids interested! To this day, I still love to read, but most don't have vibrant drawings. Plus, I have expanded beyond words. It took time and lots of practice, but now I can read numbers too.
When you're running a business you have to stretch your skills in unfamiliar ways. Like reading numbers and interpreting finance. The financial reports are one common area that confuses business owners. Financial statements are a new challenge because you haven't needed one before. Like learning to read, it's not intuitive and it takes time… but like the alphabet and words, you can learn.
Your business’s financials are critical to manage your money and set yourself up for success. Even if you have a finance pro maintaining your numbers, you need to know what it all means.
First, let's learn what reports you need to be familiar with. One at a time, we'll go through a basic introduction on the reports every business owner needs to know.
In the last few blogs, we went over how to do your bookkeeping. You know what to do on your weekly finance dates and how to wrap them up at month-end. The last step of month-end close is reviewing the financial reports. You've done all this work to create good data. Let’s start looking at the product of all this work.
The 5 Business Questions Your Financial Reports Can Answer
1. Income Statement: Is My Business Profitable?
The first report I want you to understand is the Income Statement. You may have also seen it called the Profit and Loss Statement or P&L. The P&L is the most important financial report because it serves as a basic business health check. It answers the question, “Are you profitable?”
Each line of this report details your total sales, the expenses to make those sales, and what's leftover. That remaining amount is your profit/net income.
If you're in business, you are a for-profit entity. That means the bottom line of this report is one of the top goals of your business. If your business is not generating profit, you won’t have a business for long.
An important point you should note is that this statement shows activity over time. You can run this report over any length of time, and it will sum up all the revenue and expenses during that period. Most often, you run it for a month, quarter, or year. As you start making more decisions based on your latest results, you may look at it on a weekly basis.
2. Accounts Receivable Aging Report: Am I Leaving Money on the Table?
The next report we’ll review is your Accounts Receivable Aging Report (AR aging report). This report shows what sales you've made but haven't collected the payment yet.
We look at the AR aging report because the longer invoices are outstanding, the less likely you are to collect. Invoices older than 90 days are only 20% likely to be paid.
The report shows the data in columns according to the number of days outstanding. Usually the columns are in 30-day increments, but you can adjust it as you see fit. The rows contain each customer with open invoices.
When evaluating if a balance in any column is good or bad, you need to keep your invoicing terms in mind. If you have 60-day payment terms, invoices outstanding for 30 days are no problem. But, any amounts outstanding for 90 days on 60-day payment terms, are a cause for concern. You need to follow up on each invoice with each customer.
QuickBooks makes it easy to send reminders on and chase these outstanding invoices. If you use a different program for invoicing, you may be able to send reminders there. Otherwise, you can call, text, or email each customer.
Wherever the data is, make sure you stay on top of all outstanding invoices and don't risk not getting paid!
3. Accounts Payable Aging Report: What Bills Do I Need to Pay?
The next report to know is your accounts payable (AP) aging report. In your weekly finance dates, you enter all bills you've received. This allows you to track what you need to pay and when.
The AP aging report tells you what bills are outstanding and when they are due. Like the AR aging report, it's broken into columns with 30-day increments with a row for each vendor. The amount in the Current column are the bills due now. The amounts in the 30-60-90 day columns are due at that time.
You use this report to manage cash flow. Especially if you have a lot of accounts receivable, you need to prioritize your bills. This report helps you plan which ones to pay and when.
Also, you want to keep your money earning interest in your bank accounts for as long as possible. Unless a vendor offers an early payment discount, it's best to pay bills when they are due and not before. You don’t want to risk a cash flow crunch by paying bills before they're due.
4. Balance Sheet: How Much Equity Have I Built in the Business?
The balance sheet is the second main financial report. Yet, it may not be as useful as the profit and loss for new business owners. Unlike the income statement (which shows activity over time), the balance sheet is a snapshot. It shows the balances on a specific date.
This report shows what you own, what you owe, and the difference between those two. This difference is the net worth, or equity, of your company.
There is a simple equation to understanding the balance sheet:
Assets = Liabilities + Equity
Your assets are your cash balances, accounts receivable, inventory, equipment, and the like. Liabilities include accounts payable, credit card bills, and loan balances.
The difference between assets and liabilities is the equity. This is where it gets confusing. While you can point to assets and debts, equity is intangible. It accumulates over the life of the company. The net income from the P&L flows into equity. The section also includes owner transactions, like investments and draws.
An easy way to think about a balance sheet is like owning a house. The asset is the house, and the sales price is the value on the balance sheet. The liabilities would be the outstanding mortgage balance. Any cash down payment on the house is equity. With each mortgage payment, the liability decreases and equity increases.
Said another way, the equity is the amount of the house you own free of any obligations. If you think of your business like a house, it's easier to understand what the balance sheet means.
As equity grows, it shows the value you’ve created through your company. If you decide to sell your business, you would sell all your assets and pay off all liabilities. The net cash remaining represents equity.
5. Statement of Cash Flows: How Much Cash Do I Have Right Now?
The last report I want you to start reading is the statement of cash flow. Many new business owners think that net income means cash in the bank, but that's not true. It's a complex relationship. In essence, this report is a bridge between the income statement and balance sheet.
The statement of cash flows reconciles net income and cash on the balance sheet. At the top of the statement of cash flows, you start with the net income on an accrual basis.
The body details the balance sheet account changes (ending balance minus beginning balance). It will take time to understand all the line items, which we won’t get into here.
For now, I want you to look at the bottom lines. The report total is the net income plus the sum of all changes in the balance sheet accounts. This number represents the difference between beginning cash and ending cash. It’s how much your total bank account balances grew or shrank.
To stay in business, you need cash. You need to keep an eye on cash and make sure you don’t run out. If you have negative cash flow, you could be on a troublesome path.
You have many options to manage cash, which we’ll cover in another blog. For now, get in the habit of looking at the report and monitoring your cash balances.
As the saying goes, you can't manage what you don't track. You know how to do your bookkeeping, and now you know which reports you need to look at every month and what they mean.
With time and practice, you'll connect the dots and see how the numbers relate to your operations. Your finances tell the story of your business. My goal is for you to learn how to interpret that story.
It may seem far-fetched right now. But, if you look at these reports every month, I promise it will start to make sense. You'll see how the reports relate to each other, operations, and the impact of your decisions. Keep at it! In time, your financial reading level will rise from fledgling entrepreneur to CEO.