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Balance Sheet, Financial Statements

How to Quickly Understand Your Financial Statements (Part 2)

Can a small business owner really benefit from having financial statements?

Financial statements aren’t just for large businesses.

Even if you are a one-person show, you still need to know the financial results of your business, and it is harder to track in your head than you might think. In fact, I don’t think I have met a single business owner who has been able to correctly tell me the most important numbers for evaluating their business off the top of their head.

Most bookkeeping software can calculate and present at least rudimentary reports, so I would start there and work toward well-organized and actionable ones as your business grows.

Last week, I covered two of the most useful financial statements to learn how to understand for your business. The Income Statement and Budget to Actual 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.

Your Balance Sheet

Many business owners have no idea what useful information is contained within this statement. They look at their profit and want to know where that money is and why it’s not in their pocket. The answer is usually found within the balances presented here.

Don’t get bogged down with trying to understand what goes in what section or how and why both sides always equal other, that information isn’t important to you as an owner. What you need to focus on are the balance of these accounts:

  1. Cash

    This one is pretty obvious and usually something you are tracking anyway through the bank.

    The caveat I will note here, though, is that, if you write any paper checks, you need to be aware of the difference between what has cleared the bank and what is outstanding, because it can be a significant amount, and the reason a check bounces if you aren’t watching carefully. This used to be pretty standard for businesses to keep an eye on, but as more electronic banking has emerged and fewer people reconcile their personal bank statement, the concept of “float” has gone a little by the wayside.

    The cash balance shown on your balance sheet will include all checks you have written whether they have cleared or not, and so is a more accurate representation of the available amount.

    Also note that old checks that have never cleared may just sit here, making your balance look lower than it really should be, unless you regularly review what is out there and void anything that is too old. This is something many CPAs do for you at year end, but it is good to verify that and to check on it for yourself every 6 months or so.

  2. Accounts Payable & Receivable

    This will only exist if you are on an accrual basis. If you don’t know what that is, than you likely are on cash basis, as most small businesses are. But over a certain amount of sales and for particular industries, you are required by law to file taxes on an accrual basis, so you also have to track your financials that way.

    Essentially what this means is that you are recording sales and purchases when the order is made rather than when you receive or pay the money. In some cases, there may not be a lag between these two events, but as you get larger, the lag typically increases.

    These numbers are important because they tell you how much money you are owed (A/R) that you haven’t received, even though the work is done, and how much money you owe (A/P) that you haven’t paid, even though the services or product is already used.

    It is critical to the health of your business that you collect timely the amounts that you are owed, and pay timely the amounts that you owe, but from day to day, the fluctuation in these amounts can make a big difference, especially if you are tight on cash.

    PRO TIP:

    There are a whole lot of things that a CPA can advise regarding your taxable income and the connection to A/R and A/P which are beyond the scope of this post, but there is one tip I do recommend. Be sure to review the list of outstanding items in both accounts regularly to be sure they are are still due.

    Often things get in there that were later canceled, returned, or credited that are still sitting there to be paid, and it skews your numbers, and potentially your tax.

    It is important that these amounts are accurate at year end at a minimum. These accounts can also be one of the reasons that your profit is not the amount you see in your bank account. If you have billed a lot of work that isn’t yet paid for, the profit is still showing in your bottom line, but until you receive it, it won’t show up in your cash, so that can make for a pretty big discrepancy.

    The same goes for the A/P, where you can be deducting more than you have really paid for, so your cash is higher than it really should be. Neither condition is ideal.

  3. Loans & Credit Cards

    This is often where people will forget that they have money tied up. It is important to know how much debt you have on the business books and how much you are paying toward it.

    Payments on a loan are not deductible expenses, only the interest portion is, so if you are paying down debt, much of your profit may have gone toward lowering these balances rather than in your pocket by the end of the year.

    If you increased your debt significantly, you may be showing a lot more cash than your profit, because you have bought items that you could deduct as expenses but didn’t have to lay out any cash for. Just be aware how these balances can affect your taxable income and how much debt your business can support.

  4. Personal draws

    If you file taxes as a partnership or an s-corporation, you should have a category named draws or distributions. This is the money that you as the owner take out of the business outside of your paycheck, and can include personal expenses that you paid for through the business (but aren’t deductible).

    There are a whole lot of issues surrounding this account and the topic of owner compensation in general, which I will cover in another post.

    Just remember that you may have already taken a significant chunk of your profit out of the business throughout the year in the form of draws, so you won’t see it in the bank account at the end of the year. There’s nothing wrong with that, as long as the amounts are reasonable, but if your business is low on cash, remember that you might be the reason why.

There are of course many more numbers that can show up on the Balance Sheet, as well as many other financial statements that you can calculate for your business, but if you only understand these few concepts, you will be far more advanced in your understanding than many small business owners.

Take the time to be familiar with these and watch how your business can grow as a result.

Do you have a Balance Sheet for your business? What information have you learned from it? Let me know in the comments below or on Facebook!

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