Key Financial Statements
Financial statements are summaries of business activities expressed in numerical formats. They help you:
- Identify the results of your company
- Compare your business against your industry, prior year and current budget
- Establish benchmarks to see where you are going and how you are doing
The three key financial statements are:
- Balance Sheet
This is the most important financial statement because it identifies your net worth. The balance sheet is a snapshot. It tells you where you are at a given point in time and is only valid the day it is done. While the profit and loss (P&L) statement is a historical recording that never changes, the balance sheet changes on a daily basis. The balance sheet shows:
- The economic resources (assets) of the company
- What you owe other people (liabilities)
- Any claims the owners have against the company (equity)
The balance sheet formula is “assets = liabilities + owner equity.” The goal in owning a business is to build owner equity at all times.
Current assets are anything that can be converted to cash within one year. Fixed assets take longer than a year to be converted into cash. Fixed assets aren’t for sale, but they are used in the process of making your product or providing your services. For example, the building would be a fixed asset, cash would be a current asset.
Current liabilities are debts due within one year’s period of time. Long-term liabilities are debts due after one year’s period of time. Equity, or net worth, is the claims of the owners on the business. Equity gets created in two ways — the owner(s) put money into the business or they retain earnings generated by the business.
A balance sheet has two sides. On the left side are the assets, starting with current assets. Financial accounting puts the most liquid asset (cash) first. Then come inventory, accounts receivable and prepaid expenses. The sum of these assets yields total current assets.
Long-term (fixed) assets are stated at cost. They include things like land and equipment. Next comes accumulated depreciation. Depreciation was created a long time ago as a government tool to get companies to reinvest earnings. However, that’s not how most companies use it today. Depreciation represents one of the trickiest areas on the balance sheet because it often doesn’t show the true value of the asset. If you are acquiring a company or being acquired, don’t take the balance sheet at face value. Dig deeper to find out the true value of the long-term assets. The balance sheet is just a book representation of the value of the assets. It has nothing to do with reality.
On the right side of the balance sheet are liabilities, with current liabilities listed first. These include accounts payable, notes payable and any long-term debt due within a year. Long-term liabilities include any debt that comes due more than a year out. By definition, the balance sheet has to equal. Assets will always equal liabilities plus equity. If liabilities exceed assets, equity becomes negative.
Conventional business rules are based on equity, net worth and hard assets. But the world is changing very rapidly. Intellectual property is starting to dominate the business world. For example, Amazon.com doesn’t own any inventory, yet they recently achieved a ten billion dollar market cap. Even though they have never made a profit, investors keep pouring money into the company. Will it come crashing down at some point in time? Nobody knows what will happen because the rules are changing all the time.
The rate of change is happening so fast it’s impossible to keep up anymore. Fixed assets will become like the Maginot line. The French built the Maginot line after World War II in order to keep the Germans from invading. At the start of World War II, Hitler realized he couldn’t get through it so he went over and around it. If you do business by building fortifications, competitors won’t try to penetrate them. Instead, they will go around them and you will get stuck with a lot of useless assets.
Start looking at getting a very fast return on hard assets, especially if technology is changing in your industry. Be very careful about making long-term asset purchases. Instead, look at leasing. It may cost a little more up front, but it will give you much more flexibility down the road. The rate of response will be critical for most businesses, and the window of opportunity is getting smaller all the time.
Key balance sheet ratios include:
- The current ratio answers the question, “Are there enough current assets to meet our current liabilities?” To determine the ratio, divide current assets by current liabilities. Banks generally like to see ratios of 2:1 or 3:1, meaning the company has two or three times more current assets than current liabilities. This ratio loses importance if you don’t have any bank financing.
- The quick ratio answers the question, “Are there enough liquid current assets to meet our current liabilities?” The quick ratio removes inventory from current liabilities because if you have to liquidate, you never get full value for inventory. Banks generally like to see quick ratios of 5:1 to 1:1.
- The working capital ratio answers the question, “Is there enough money to get through a short-term reduction in the business?” To determine this ratio, subtract current liabilities from current assets.
- The debt-to-worth ratio answers the question, “How much of the company is financed by borrowing?” To determine this ratio, divide total liabilities by net worth. Banks like to see ratios of 2:1 or less. If your business is built on intellectual property, they will usually let the ratio go higher. Banks use this ratio to determine their risk factor when lending money to businesses.
- The days receivable ratio answers the question, “Are we collecting the monies that people owe us?” There are several ways to calculate this ratio. One of the most common involves dividing 365 (days in a year) by the quotient of net sales divided by receivables. To figure out your avenge receivables, add the receivables for the previousl2 months and divide by 12.
To improve your balance sheet:
- Increase inventory turnover. This helps the balance sheet by increasing cash. It also cuts down on your risk because inventory always carries a certain amount of obsolescence risk.
- Consider lease versus purchase of equipment. Conduct an ROl analysis. It may make more sense in the short run to lease, especially if technology is changing quickly in your industry.
- Reduce the time it takes to collect receivables. Get some focus in this area. This is the easiest area to increase cash flow if you pay attention to it.
- Get increased dating terms. Vendors can be a good source of financing. If you can extend your payables to 60 or 90 days without increasing the cost of goods, you can get your vendors to finance the business. Always get your price first, then go for additional dating.
The more attention you pay to receivables, the faster you get paid. Every week, have your CFO call the top three past due accounts and say the following:
“Hi, I am Joe Jones, CFO of XYZ Company. I’m calling to thank you for your business, we greatly appreciate doing business with you. We have a little problem that I know you’re not aware of. Every month when we send out our invoices, we get paid 60 days late. Some clerk in your accounting department sticks them on the bottom of the pile. I know you’re not aware of this because I know you wouldn’t let it happen. I haven’t built the cost of money into these invoices and I don’t want to do that. But I can’t afford to let the money sit out there. I’m going
to be writing our invoices in the next few days and I would love to send it directly to your attention. That way I know they will get paid.”
This approach doesn’t blame the other CFO. Instead, it blames a third party that probably doesn’t even exist. You don’t want to kill the relationship with the company but you do want to get paid. With this approach, you will get paid on time nine times out of ten. Plus you build a relationship with their CFO.
- Profit and Loss (P&L) Statement
The P&L statement shows:
- Revenues
- Expenses
- Net income (or loss) over a defined period of time
It answers the question, “How effective are we at taking our sales and revenues and generating a profit for a fixed period of time?” Key P&L formulas include:
- Revenues – expenses = net income.
- Net sales – cost of goods = gross margin. (If you’re in a service business and you don’t have cost of goods, sales is gross margin.)
- Gross margin – SG&A (selling, general and administrative) expenses = net operating profit.
- (Net operating profit + income) – (other expense + taxes) = net profit.
Common P&L terms:
- Cost of goods sold. This is the total price you pay for products that were sold. (It does not include SG&A expenses.)
- Gross margin. This is the excess of sales revenue divided by cost of goods sold.
- Selling expenses. These are costs incurred to make the sale, such as commissions, advertising, warehousing, etc.
- General and administrative expenses. These are expenses incurred (rent, travel, etc.) that are not associated with sales activity.
- Other income. This is money that comes into the company as a result of non-operating activities. One example would be selling an asset for more than you paid for it.
- Other expense. This is the opposite of other income. For example, if you sell an asset for less than you paid for it.
P&L action steps:
- Leverage sales over fixed costs. This is the name of the game in business — getting more effective and efficient so you can improve sales without increasing costs. Look for ways to maximize sales with existing customers. Call your top 20 customers and ask, “What kinds of things are we doing to create value for you? What could we do to earn more of your business?” Other activities to leverage sales include:
- Prospect for new customers.
- Work on closing skills.
- Sell at the right level. Don’t waste time trying to sell to people who can’t make the decision.
- Identify segments of your business where more potential exists.
- Make the sales team accountable for desired results.
- Make sure the compensation program for your sales team is in alignment with the best interests of the company.
- Pay sales people for sales that get collected, not just for making sales.
- Increase gross margins.
- The best way to increase gross margins is to become a good negotiator. Put all your sales people through negotiations training.
- Review pricing opportunities. Give lower costs in rebate form after customers achieve certain performance levels. This allows you to keep the cash flow, plus it forces customers to perform in order to receive the discount.
- Review how you incentivize the sales mix.
- Do a zero-based review. Don’t let your people automatically submit budget increases every year. Instead, have them start with a blank piece of paper and cost-justify everything they do.
- Cross-train your team members.
- Compensate for productivity instead of time. Have some element in your compensation program that is tied to productivity. When you pay for time, you get time, which requires more supervision.
- Outsource when economically advantageous. Study your processes and look for things that other companies can do cheaper. Or, you may be so good at certain things that you can do it for other companies.
- Use your resources creatively. Look for ways to turn dead expense into money makers.
- Cash Flow Statement
With cash flow, all you need to know is whether you have more money coming in than going out. The cash flow statement answers the question, “How did the money come in and where did it go out?” All changes in cash flow fall into one of three categories:
- Operating activities
- Investing activities
- Financing activities
There are two methods of calculating cash flow: direct and indirect. They both give the same number. The direct method subtracts the cash that comes in from the cash that goes out. Internal accountants prefer this method because it’s simpler and more direct. Outside CPA firms prefer the indirect method because it is more complex and helps to build their fees.
The indirect method starts with the P&L net income figure and adds in any P&L activities that didn’t involve any cash and any non-P&L activities that did involve cash. Many activities involved in figuring net income have no cash implications. These include things like depreciation, amortization, deferred taxes, changes in inventory and accounts receivable.
Anything on the P&L and balance sheet that affects cash affects your cash flow. For example if you increase sales and get paid for the sales, cash flow goes up.
Cash flow action steps:
- Focus on your sales mix. If you sell higher margin items, you will have more cash after paying expenses.
- Incremental sales. If you can leverage more sales over existing costs, you will make more money and have more cash.
- Reduce acquisition costs. Lean how to negotiate better.
- Reduce expenses.
- Use performance-based compensation. Pay people after they get the results, not before.
- Negotiate performance-based incentives with your customers rather than giving immediate price concessions.
- Wherever possible, get extended dating from vendors. Negotiate cost first and then ask for extended dating.