I’ve had to explain fundamental financial concepts to seasoned business owners a few times in my consulting and accounting career. I’ve spoken with VPs of multibillion-dollar corporations who were perplexed, as well as new business owners who couldn’t comprehend why they had to pay tax on a million dollars. In both scenarios, highly successful businesses lacked a simple explanation for what their numbers meant.
It’s sometimes difficult for business owners to see the big picture of what’s going on because they’re so busy running their company. It cannot be easy to distill all of the information available to everyone online into useful knowledge. It’s all too easy to become so engrossed in the details that we lose sight of the forest for the trees. This is especially true in accounting systems for businesses.
A business owner can review various reports to assess and better understand their company’s financial health. There are numerous reports available with cloud-based accounting. The issue is information overload: how do you decide which report to read and what information is relevant? Here are a few pointers to help you understand the three main reports, how they relate to one another, and how to quickly apply them to your business.
Profit and Loss Statement
The income statement is probably the most detailed report to comprehend. It’s the profit your company made from selling products or providing services minus the costs it paid to provide those products or services. Keep in mind that the income statement excludes any loan payments or asset purchases. Most of the time, it’s what’s not on the income statement that business owners need to know more about.
The balance sheet is the second most common report, and it’s beneficial because it displays the balances in all of your accounts. This report may only include your bank account, or it may be the backbone of your business if you have a lot of assets, depending on your industry. In accounting, the balance sheet is almost entirely based on historical costs. This means that if your company bought stock for $500 30 years ago, it would still be listed as a $500 asset rather than its current market value.
Cash Flow Statement
The cash flow statement will show you how much money is coming in and going out of your company that didn’t make it to the income statement. For example, if you took out a loan, you would have a large deposit in your bank account; however, this is not taxable income, so it will not appear on your income statement. The cash flow statement also shows how much money was distributed as dividends to owners or investors.
Increases and Decreases in Bank Balances
One of the most common problems I see is that business owners cannot explain why their bank balance has changed. To summarize, you use cash (a decrease) to buy assets, you get cash (an increase) if you take out a loan, and you either receive or spend cash if you receive or distribute money to owners. If a company does not take out a loan, the increase in cash must be equal to the net income.
KPIs can help you simplify things.
You don’t have time to sift through the numerous financial reports and try to figure out what’s going on as a busy business owner. You probably have a better intuitive sense of your company than the accounting system. Using Key Performance Indicators, or KPIs, you can connect the intuitive and the financial. Your intuition may be sound, but it’s even better if data back it up.
Many articles will explain how to prepare the income statement, balance sheet, and statement of cash flow. These articles are excellent, but the majority are overly technical and do not adequately relate to the reality of the numbers. As you decipher your financial statements, keep these simple concepts in mind. Without the headaches and number crunching, relating the numbers to your reality will give you a much better understanding of your overall business.