Running a business is all about information. The more you know, the more informed your decisions are. And when your decisions are better-informed, your chance of success is higher.
Financial statements are the best way to get this information. They open your eyes to potential pitfalls or alternatives you can explore when making a decision. However, I often meet small business owners who don’t use this valuable tool, so I’ve put together a quick guide on reading the different kinds of financial statements and figuring out what they’re telling you.
Let’s start with the income statement. It’s a basic breakdown of your sales less your expenses for a given period (let’s say last month). This is pretty simple math: if the sales over the last month are greater than the expenses the income statement will report a profit. Good. If the expenses are greater than the sales, they’ll report a loss. Not as good.
So let’s say the income statement told us we had more sales than expenses last month. But that’s only part of the story. If we’re only looking at a month’s worth of sales, we can’t rely on it as an indicator of the future. It could have been one booming month. It could have even been one big sale that made the whole month look good.
Since looking at one month at a time is limited, we can make the income statement more effective by adding prior periods into the report so we are viewing results from multiple periods at one time. This gives us a much better idea of trends – are sales trending upwards? Are expenses trending upwards to match them? Is the opposite true? Armed with a few months of information, we can use the income statement as a much more effective tool to investigate potential problems before they hurt the business.
A great trend to look at when you’re using the income statement over a period of time is profits and expenses as a percentage of sales. That way you can quickly see if increased spending is helping to increase sales or simply hurting profits.
Where is the money?
So if you have a profit on your income statement, that’s great. But we also have to remember something: cash is king. Profit on your income statement isn’t always money in your bank account.
If our booming month was from one big sale, we’re not actually going to see the results of that booming month until we’re paid for that sale. So a great sales month doesn’t necessarily mean we have cash right now.
To drill into this, we need to look at the balance sheet, which is a snapshot in time that shows the dollar amount of assets and obligations of the business. The way the balance sheet is formatted helps us see which assets we can expect to convert to cash in the very near future (accounts receivable) and which obligations we’re going to need to pay soon (accounts payable). Put another way? Our sales will become cash quickly, but our bills will take cash from us quickly. That’s in contrast to things like bank loans that we won’t have to pay until far in the future (non-current liabilities).
When’s the money coming?
This is where the cash summary report comes in. Like the income statement, the cash summary report shows activity for a certain period of time. But rather than just reflect invoices, it shows the change in cash coming into and going out of the business. It’s an income statement based on when you pay and get paid rather than when you invoice and get invoiced. That’s a big difference, because you can’t pay your $10,000 bill due on Wednesday with a $20,000 sales invoice that’s coming in on Friday. Your supplier needs cash.
So as you can see no one financial statement tells the whole story. Each statement gives you a different detail, and combining them is the only way to truly know your business’s strengths and weaknesses. And when you know its strengths and weaknesses, you have all the information you need to truly take control of its future.
If you want to find out more about reading financial statements, give your accountant a call. Or, if you’re in between accountants at the moment, have a look at our advisor directory to find Xero experts who can talk you through everything you need to know.