In addition to face-to-face counseling, several of our SCORE volunteers do cybercounseling. The SCORE national office receives inquiries from small business owners and assigns those questions to individual SCORE members who have volunteered to do Internet-based counseling.
I received the following question:
"I recently started a small business and am wondering about my financial statements. I am somewhat confused with the terms and don't know how much I need to know. Can you help me?"
This is my response, listing the four most essential statements:
The balance sheet shows the financial condition of your company at a particular point, usually month-end or year-end. This statement lists your assets, your liabilities and your net worth, which is the difference between your assets and liabilities. Remember that this picture can change from day to day so should be updated and reviewed routinely.
Next is the income statement, sometimes called the profit and loss statement, which shows whether you made a profit or loss during a particular period. This statement lists all of your sources of income and subtracts the expenses incurred to operate the company. The net result will determine whether you had a profit or loss for that period.
Cash flow statement
Arguably the most crucial financial statement is the cash flow statement. It is very important that you understand that it is possible to show a profit on the income statement but have no money to pay the bills. This could happen because the income statement could reflect revenue billed but not yet received and expenses incurred but not yet paid. Cash flow records show all cash as it comes in and as it goes out. The bottom line of the cash flow statement must be positive, showing that you have the money in the bank to pay your bills and take advantage of business opportunities when they arise.
An annual budget is part of the financial management process. Comparing the income statement to the budget will let you know where you stand versus plan. During the startup of the business, I'd expect to see deviations from the budget. Consequently, the business owner either needs to update the budget or start making changes to the business.
With a basic understanding of these statements, business owners can compare them with statements from prior periods and determine whether something needs special attention.
In addition to the four types of statements there are several measures, known as financial ratios, that are helpful for the business owner to examine. They should be compared to prior periods and can be compared to those of other similar companies and national averages.
Current ratio is current assets divided by current liabilities. It tests ability to pay current bills and is a measure of liquidity.
Debt to equity is total debt divided by equity and is a safety issue. Are you taking on too much debt?
Gross profit margin is gross profit divided by sales.
Return on equity is net income divided by total equity. This ratio is a measure of profitability.
Accounts receivable turnover is credit sales for the year divided by average receivables. This tests efficiency on how fast you collect payment.
Inventory turnover is cost of goods sold for the year divided by average inventory. It tests efficiency: Are you moving your inventory?
All business owners need to be comfortable reading and analyzing financial statements. They can tell you how things are going, what's going well and where there may be problems.