Financial Statement Basics for the Business Owner
Business owners, especially those who are successful at generating profits, put most of their effort and concentration on their products and services, pricing, sales, and customer relationships. Keeping those profits, as well as leveraging them for growth is another area of concentration that involves the financial health of the business. Especially when growth requires proper use of debt, understanding the financial health of the business is how lenders make decisions.
Though the average business owner is terribly busy running the business, they also must spend some energy in understanding how to analyze the health of the business using financial analysis and statements. Generally, owners fall into one of these financial analysis buckets:
- Highly detail oriented, spending enormous time and effort in “running the numbers” to see how they are doing. They can sacrifice business operational efficiency or delegate it due to their focus on the financial numbers.
- Knowledgeable about how financial statements and ratios work, but they leave all of that to their accounting and financial advisors. They take advice and act upon it for the next year.
- Clueless, totally production and delivery oriented, and surprised by what they are told every time they meet with their accountant. They often are late to react to financial warning signs.
That middle group are the ones who usually do best at both the operational and the financial aspects of the business, but a little more knowledge about how financial analysis works can help everyone in their next meeting with the accounting or tax consultants planning for growth.
Basics of the 3 Financial Statements
“Financial statement analysis is a process to select, evaluate, and interpret financial data in order to assess a company’s past, present, and future, financial performancei.” The three basic financial statements are:
The balance sheet is a breakdown of what the company owns, the assets, and what it owes, the liabilities. When investors evaluate a company, they look at three pillars of quality:
- Capital adequacy
- Asset performance
- Capitalization structure
They do this through an analysis of the three components of the balance sheet: assets, liabilities, and equity.
The income statement looks at income and expenses. It indicates the profitability of the company. Spending patterns emerge and can be an early warning of potential problems. Recurring expenses, as well as non-recurring, are analyzed with an eye toward how they can be reduced for efficiency and profitability.
On the income side, year-over-year numbers, especially when compared to inflationary trends can be early warning indicators. When costs are rising but revenues are stagnant, both expenses and pricing must be analyzed to see where improvements can be made.
Cash Flow Analysis
Sometimes business owners are surprised by a cash flow crunch that can threaten the survival of the business. They are surprised because they see income over expenses that shows a nice profit, but suddenly they do not have the cash on hand to pay the bills. The cash flow analysis statement shows the inflows and outflows of cash over a period, with the result being either positive or negative. Investors and lenders rely heavily upon the cash flow of a business for decisions.
Understanding what your accountant is looking for in your financial statements can aid in making the most out of your meetings and financial planning.