Financial Statements

How to Quickly Understand Your Financial Statements (Part 1)

Do your eyes glaze over when you hear the words financial statements?

Most small business owners start to tune out when it comes to numbers, but some very valuable information can be learned with just a simple understanding of these reports.

As the owner, you should at a minimum be familiar with the Income Statement (Profit & Loss) and Balance Sheet for your business. I would also recommend creating a budget and becoming comfortable with the Budget to Actual Report. These reports can be critical to the growth of your business.

This is also an area where I recommend not relying solely on your CPA and instead learning how to read the details of these statements on your own, knowing that your CPA is looking at the big picture.

This is because, although a CPA can point out some balances that seem off, they do not typically have enough inside knowledge of your operations and industry to know where some of the numbers don’t make sense. Plus, unless you are talking to your accountant weekly, you should really be reviewing this information more often than you are contacting him or her.

There aren’t many things that can be corrected after the fact, so it pays to catch problems as they develop and before they cost you money. And if your business is too small for a CFO, then you as the owner need to be the one looking for these problems.

So let’s break down the reports I mentioned and what balances you need to understand on them.

Income Statement:

If you have looked at any financials in the past, it is usually this one, because it is the most tangible to the typical business owner. It presents a sum of your income and expenses over a particular period of time, with the difference being your profit.

Let me point out here that ‘income’ and ‘profit’ are not the same thing, although many people use them interchangeably. Income is what money came in, usually your total sales. Profit is what money is left over after expenses, or can be a loss if your expenses exceed your income.

In order to understand your Income Statement, you need to look at these numbers:

  1. Total Income/Sales – you should have monthly goals for what your sales are, or at a minimum know how much you have to bring in on average per month to make ends meet. You need to track this to make sure that your sales are where they need to be in order for you to make a living.
  2. Cost of Sales (Cost of Goods Sold) – if you are selling a product rather than a service, you should definitely have this item on your Income Statement. It may also be referred to as direct costs, and represents your cost of the items that you sell, including wholesale price, shipping in/out, or materials to manufacture/build the items that you are selling.
    It should also include the cost of any employees who work directly on building those items. If you only work in services, don’t worry about this. But if you sell a product, you need to know how much it costs you in total so you know how much you can potentially profit off those items, and how to price things for sale. This number can tell you if you are underpricing something or if your laborers are taking too long to build something.
  3. Expenses – this depends on the industry, but you should know what your top 3 expenses are, and about how much they should be monthly. For most businesses, they include rent, wages, and one other item directly related to their industry, possibly software, supplies, gas, or repairs.
    Keeping an eye on these items will ensure that you don’t spend more money than you should on your most common expenses, or at least will make you more quickly aware when you are spending too much. This is one where a CPA may not know what is common for your business, but you should, based on your everyday experience working on the business.
  4. Profit – this is your bottom line, the amount of money you have “on paper” after paying for all your costs. It is typically also the amount you will be taxed on, depending on how your business files taxes and how many non-deductible items you include in your expenses.
    Your profit is important, of course, because you need to make money to make a living, so this should be an amount that will provide for your family as well. It needs to be closely watched to be sure that it is worth it for you to be running this business.

Budget to Actual Report:

Related to the Income Statement is the Budget to Actual Report. As its name implies, it takes your budget and compares that to the actual numbers from the Income Statement.

The larger your business becomes, the more important it is to create a budget and review your financial results compared to what you have forecasted. If you are trying to grow, you need to map out the financial journey it will take to get there, and the way to do that is with a clear budget.

Depending on the size of your business, it may not need to detail every item that you spend money on, or be very complicated at all, but it does need to at least address the categories we discussed that are on the income statement: sales, cost of sales, expenses, and profit. That way, you can match up those budgets with the actual numbers from your income statement in order to review your results.

There is an additional column that is either the dollar or percent variance (or you can see both). This is the dollar amount or percentage that the budgeted amount is different from the actual amount sold or expensed. Look for the largest differences and investigate what the reasons might be for them.

In the beginning, it may just be that your budget was overly optimistic, but as time goes on and you adjust it based on your business, variances should not be very large without a good reason. This will also typically give you the fastest feedback if you are trying to discover why your profit is smaller or larger than expected.

The variance is also good for revealing when an expense that is usually the same every month (fixed expense) is suddenly different, since those should show no variance in a given month.
Both of those reports show you a good snapshot of your monthly results, but they are not the whole picture. There can be many more things that you pay for that are not covered in the income statement, which is why you also need to understand your Balance Sheet. The details of that report are covered in Part 2.
Are you comfortable with your understanding of your Income Statement? Do you have a budget for your business? Let me know in the comments below or on Facebook!

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