When I ask startup founders and entrepreneurs why they started their businesses, the answers vary widely. Many recognised a problem and had an idea of how it could be solved. Some thought of a truly innovative product or service. My point is that no one ever says they started their business because they liked numbers. However, becoming familiar with the basics of business finance – or numbers – is critical to business success. Plus, understanding the basics needs to be neither tedious nor difficult.
Three Key Financial Statements
As a business owner, founder, or entrepreneur you need to have a good idea of your company’s finances. Without understanding income, outgoings, and debts it is impossible to spot risks and prevent or mitigate them. You would effectively be in the dark about how your company is doing – not a good position.
There are three key financial statements anyone running a business needs to understand:
- Balance sheets
- Profit & loss statements
- Cash flow statements
Here is a closer look at the characteristics and interactions of all three basics of business finance.
1. Balance Sheets
Your balance sheet shows you at a glance what your company owes and owns at a specific point in time. It also shows the amount that shareholders have invested in the business.
Balance sheets list your assets, liabilities, and shareholder equity. They are a snapshot of your company’s wellbeing. Balance sheets are limited in one respect: you can’t evaluate trends or developments based on one single balance sheet without comparing it to previous periods.
All balance sheets adhere to an intuitive accounting equation:
ASSETS = LIABILITIES + SHAREHOLDER EQUITY
Think of it this way: the company needs to borrow money (liabilities) or use money already invested by shareholders to pay for its assets. For example, if you take a bank loan of £5,000, your (cash) assets will increase by that amount and so will your liabilities. This balances the equation. When you start generating revenue that exceeds your expenses, those appear as cash assets, investments, inventory, or any other assets.
Banks, investors and credit rating agencies derive several ratios from the balance sheet to assess a company’s financial situation. Comparing debt to equity is one of those.
2. Profit & Loss
A profit & loss statement (P&L) summarises the income, costs, and expenses a company has incurred over a specific period of time. It is also known as an “income statement”, which, in most cases, covers a fiscal year or a quarter.
Comparing balance sheets and P&L statements, one of the biggest differences is that a balance sheet refers to one specific point in time, whereas a P&L document covers a period.
Obvious as it may sound, your P&L statement starts with a top line (sales or revenue) and finishes with your organisation’s bottom line (profit or loss).
In between are numbers referring to different costs and expenses, including overheads, cost of goods sold, taxes, interest expenses, and any other outgoings your business had. What’s left is your bottom line or net income. P&L statements register income and outgoings when they are incurred as opposed to when they actually arrive in or leave your bank accounts.
This statement helps answer the question of whether the company is profitable. It also shows how profits can be increased, for example by increasing sales or reducing costs. Making losses isn’t necessarily a bad thing as long as you have the cash reserves to cover them, which brings me to:
3. Cash Flow Statement
Even if your company appears to be profitable according to your P&L, you may struggle to manage cash flow. For that reason, it is important to consider this third financial statement as well as the other two.
Your cash flow statement shows money coming in and money going out. It is usually divided into sections referring to operations, investment, and financing. A positive cash flow means you can pay employees, debts, purchase inventory, etc. A negative cash flow means your liquid assets are decreasing and you might find it hard to pay your bills.
How can you struggle with cash flow even though the company is profitable? The answer is timing. If there is an imbalance between the payments you have to make to suppliers and lines of credit your business offers to customers, cash flow can become difficult unless you have adequate working capital (more about that in a forthcoming post).
Here is an example: you receive an order worth £1,000. The profit you make from the sale will be £400. You need to buy materials worth £350 and pay for them now. The rest of the costs (£250) come from recurring operational expenses. You need ten days to fulfil the order, and the customer will pay within 60 days of delivery.
Your P&L statement will show that the order is profitable. However, your cash flow may be negative for more than two months, unless the customer chooses to pay early.
Knowing your cash flow is critical to allow you to operate freely in the short term and create a buffer for unforeseen financial challenges.
Conclusion: The Basics of Business Finance
Between balance sheets, profit and loss, and cash flow statements you see the full financial picture of your company. All three are key to understanding your company’s financial situation and spot opportunities as well as flag potential threats.
Apart from internal use, banks and potential investors will also scrutinise your finances. They base part of their decision on these documents when evaluating your company’s potential for future growth and deciding if they want to be part of it.
Whilst finance, bookkeeping, and accounting may not be your favourite topics, being able to read those three statements is critical to your company’s survival. If you want to know more about how to use them to your advantage, contact us today. We love dealing with numbers!