Importance of Financial Statements
September 11, 2017
In a small business cash is king. Cash is needed to pay bills, make payroll, and meet other short term obligations of the business. Obviously, profit is important also.
However, you can be profitable but run out of cash. You can also have cash and be unprofitable. Being unprofitable too long will use up cash. If it is not possible to inject more cash, you may be out of business. With that being said, what are the drivers of cash and profit? What tools can you use to better manage cash and profit? The tools are the profit and loss statement and the balance sheet. They are both important, and it is crucial to regularly produce these statements and understand them in order to make good management decisions. Equally importantly, you need to ensure that the information used in producing financial statements is accurate. Otherwise, it may be a situation of garbage in, garbage out.
Lenders use financial statements when making business loan decisions or when they are evaluating an outstanding loan. Accountants use them to assist with tax preparation and other financial guidance. Just as important, regular financial statements allow the owners and managers to understand the financial health and make decisions to improve the business.
The profit and loss statement should be created on a regular basis, such as monthly or quarterly. It shows profit or loss from business operations over a period of time by taking revenue and subtracting expenses related to operations. This statement helps spot trends in sales and expenses as well as trends in gross margin and net profit margin. It is a good idea to express expenses and profit margins as a percentage of sales, as this will make it easier to compare percentages across months, quarters and years.
The balance sheet is a snapshot of financial health and shows the business assets, liabilities and net worth at a particular point in time. It is also important to produce a balance sheet on a regular basis in order to spot trends much like the profit and loss statement. The comparison can be made between months and years by also expressing assets and liabilities as a percentage of total assets.
Having monthly profit and loss and balance sheet statements will allow you to calculate some key ratios, which are relationships between two numbers. By using the p & l, profitability ratios can be calculated. They include the gross margin ratio, which is the relationship between sales and gross profit, and net profit margin, which is the relationship between sales and net profit. In addition, liquidity ratios can be calculated by using the balance sheet. These ratios can determine the ability to pay bills and other short term obligations as they come due. The current ratio shows the relationship between current assets and current liabilities and reflects the firm’s ability to meet its short term obligations. Other ratios show number of days it takes to collect accounts receivable and the number of days of inventory on hand. An excessive number of days, in either case, is a major drain on cash.
It is important to compare profit and loss and balance sheet performance with industry peers, meaning other businesses in a similar industry. Every industry is different so comparing ratios will give a good indication of how a business is doing.
For help with preparing and understanding your financial statements see your accountant. The advisors at the ASU Small Business Development Center can also be of assistance in helping you understand the meaning behind the numbers which will help you make good management decisions. We can also provide industry averages for your industry.
“Business Tips” was written by Mr. Dave Erickson, Director and Certified Business Advisor, of Angelo State University’s Small Business Development Center. For more information on the topic of this article or the services of the ASU · SBDC, contact him at David.Erickson@angelo.edu