Guest Column: Basic financial documents you can’t ignore

Published 10:05 am Tuesday, February 28, 2017

I confessed last week that I absolutely hate to do business accounting tasks. But, in my business experience, that forced me to admit that I needed help to do these tasks, and so I always was able to find qualified, skilled people to do them for me. But, my experience and observations lead me to the realization that in many ways, money is the language of business — but often it takes some time before entrepreneurs feel comfortable speaking that language. If you don’t develop some basic financial knowledge and understanding, you risk missing red flags that might indicate problems with how you’re managing your business and its money.

Dean Swanson

Dean Swanson

With the help of three key financial statements — balance sheet, profit and loss (P&L) statement, and cash flow statement — business owners can stay in tune with the financial health of their businesses.

According to SCORE mentor and retired CPA Frank Curtis, “These financial statements are the keys to understanding any business. In a very precise way, you can determine if your business is growing and succeeding or failing.”

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Balance sheet

This financial statement lists the assets, liabilities and equity of your company at a specific point in time. Its purpose is to provide a view of your company’s financial position (its net worth) through displaying what your business owns and owes.

Profit and loss statement

Also known as an income statement, the profit and loss statement is a financial statement that summarizes your business’s revenues and expenses during a period of time — typically a year or fiscal quarter. By reviewing your P&L, you can gain a better understanding of how your revenues and costs affect your profitability.

Cash flow statement

This financial statement enables you to see your company’s sources — and uses — of cash over a specified period of time. It can be used to understand your business’s performance trends, which might not be evident using just your balance sheets and P&L statements.

As a small business owner, your company’s success can depend on you paying attention to these key financial statements.

“If you review your company balance sheet, you can learn how much cash you have on hand, how much you owe and how much equity you have in the business. Your annual profit and loss statement will tell you if you have made a profit and how much. It will also assist you in preparing your income tax return,” explains Curtis. “Good financial statements are essential if you need additional funding for your business. Any lender will require these documents before providing additional funds.”

You don’t necessarily need to be an expert in financials to successfully manage and grow your business. In fact, you should consider periodic consultations with an accounting professional to put you on—and make sure you stay on—the right track. But as a small business owner, you should have a basic understanding of what these financial statements are telling you about the well-being of your company.

I suggest that CEOs take the time to also dig a little deeper into what these documents show about your business. Here are four key terms and ratios to know. These are based on an article that I read that was written by Daniel Kehrer, founder and managing director of BizBest Media Corp. as published by SCORE on their website. Kehrer provides a concise summary.

The debt-to-equity ratio compares total debt to owners’ equity. Both numbers come from your balance sheet. To calculate a debt-to-equity ratio, divide total liabilities by owners’ equity. If a business has a debt-to-equity ratio of 2-to-1, for example, it means that it is taking on debt at twice the rate that its owners are investing in the company.

Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period. To calculate this ratio, divide cost of sales by average inventory for the period. A 2-to-1 ratio means the company’s inventory turned over twice in the reporting period.

Operating margin shows percentage of profit for each dollar of sales. It compares operating income to net revenues. Both numbers come from the income statement. To calculate operating margin, divide income from operations (before interest and income tax expenses) by net revenues. Operating margin is usually expressed as a percentage.

Working capital is the money leftover if the business paid its current liabilities (debts due within one year) out of its current assets.      

Dean Swanson is past chairman of Southeast Minnesota SCORE.