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The ABCs of Understanding Financial Statements (Part 1 of 4) - May 17, 2010

Posted by: Stu Lipkin in Articles

Many entrepreneurs and small business owners have been in business several years and know their products/services like the back of their hands. However, many of them DON’T KNOW (or understand) their financial statements. In many cases, the business owner is so focused on the operational aspects of the business; he/she doesn’t invest the time to learn about the financial side. This article (and the next 3 to follow) will be geared toward those owners. It’s a basic understanding of financial statements and what they mean to a company.

The first step in understanding financial statements is to get a clear definition of what they are. If one were to pick up a financial report prepared by an outside accounting firm, it would have several components to it. While there may be different “added” information from one report to another, there will always be three core reports. They are the:

Balance Sheet = snapshot of the financial situation at a given point in time.
Statement of Income-= financial results over a given period of time.
Statement of Cash Flows = cash inflows and outflows over a given period of time.

In future articles, I’ll be addressing each one of these reports in more detail.

So the real question is…”why do I need financial statements in order to run my business?”

> Understand the financial health and performance of the organization.

> Create and evaluate strategy and tactics to support the organizations vision and mission.

> Evaluate the financial ramifications of opportunities and investment decisions.

An analogy to this question can be found in sports. In football, if a quarterback doesn’t have a playbook and tries to direct each player on the field just prior to each play, he would surely have a losing season. The playbook is customized to the unique talents of each player and executed as a team. Financial statements have a similar role in business. While they cannot (nor should be relied upon) to forecast future events, they are a strong set of documents that defines to the business owner what has been successful and not successful over that period of time. It’s a quantitative report card that evaluates the performance of the owner and every key employee. If used properly, it should become a tool for the business owner and part of the playbook.

There is a basic premise as to how financial data should be recognized. There are two basic methods…the cash method and the accrual. The cash method recognized income and expense items only when there is an actual cash transaction. For example, sales are not recorded until the customer actually pays for the product/service. Similarly, expenses are recorded in the period when payments are made to the suppliers. Because this method doesn’t necessarily match the transaction to the period in which it occurred, the accrual method of accounting is more widely accepted. This method records all transactions in the period in which the event occurred. Sales are recorded when the product/service has been delivered. A corresponding entry to accounts receivable is also recorded as an asset to reflect the fact that the company is due the money. Even though collection of that transaction may be 30 days (and often longer), the sale is recorded in the current period. Expenses are tried the same way. The expense gets recorded at the time the product/service has been received and not when it has been paid for. The corresponding entry becomes an accrual (liability) on the balance sheet and remains as such until the vendor has been paid.

The question always arises that asks, “which method is better for my business?” Since in most cases the method can (and probably will) differ between tax and book purposes, this article will address focus strictly on the book reporting. Many small business owners prefer the cash method of reporting. They understand it better and it helps them to manage cash within their business. If the business doesn’t have the financial expertise to manage cash by utilizing other tools and techniques, then the cash method is the best. Since “cash is king” to every business and needs to be a top priority, then the cash method of accounting will be best. However, there are some very significant illusions that will occur under the cash method. For example, a construction company that takes 6 months to complete a project will probably show significant losses in the first five months because it is incurring payroll and other overhead expenses with a minimal amount of collections until the job is completed. At month 6, the company will show a large profit upon final collection for that job. Therefore, on a cash basis, months 1-5 will likely show losses and month 6 will be a significant gain. If you now combine several jobs at different phases of completion, you can see how the financials will become a roller coaster.

Under the accrual method, the revenues and expenses will be matched in the same period (month) so you will see a better reflection of the profits/losses of that company. As you can see, the accrual method is the more accurate way to record transactions. Again, it’s extremely important that the business implements other tools (cash flow forecasts) to project and manage cash requirements.

Next month’s article will address the balance sheet. It will explain the meaning of the various sections and how it is used to determine the financial stability of a company. See you then with…”Battling the Balance Sheet.”