No matter where you are in your career, you need to be able to understand financial reports so that you may plan, ask the right questions, hedge off disaster and grow. I meet entrepreneurs every week that believe that passion for their product or service is enough to succeed. I continually encounter executives who leave the finances of their organization to an accountant or vice president of finance without oversight. As is referenced in Michael Gerber’s book “The E-Myth Revisited: Why Most Small Businesses Don’t Work and What to Do About It” leaving the finances of your organization to others is the primary reason that entrepreneurs fail. It is also a reason that leaders don’t rise to the top – because they’d rather spend time focused on what they know and love, leaving the foundation of their operation to chance. I am a fan of concentrating on what you are good at and surrounding yourself with people who have your weaknesses as their strengths – but when it comes to finances you just plain have to understand the basics.
Fiscal Year: A fiscal year is any 12-month period that a company uses for accounting purposes. It may begin on January 1st. It may begin on July 1st or any other day of the year and lasts for 12 months.
Balance Sheet: This reflects the assets, liabilities, and the owner’s equity at a given point in time. Essentially it shows on any given day what the company owns, owes and how much it is worth. It’s a snapshot of the business’s value. It always balances: assets = liabilities + owners’ equity. Owners’ equity = assets – liabilities. All other financial statements flow to the balance sheet.
Income Statement: An income statement shows revenues, expenses and profit for a specific period of time – generally a month, quarter or year. This is often called a profit and loss statement, P&L, statement of earnings or statement of operations. The word “consolidated” may be placed in front of these words. The bottom line of these statements is the net profit of the service line or business.
Operating Expenses: These are the costs of running your business or service line on a day to day basis. They include all of your expenses: salaries, benefits, advertising, insurance, legal fees, and printing among others. Operating expenses are listed on the income statement and are subtracted from the revenue to establish profit. You will compare your budgeted expenses to your actual expenses monthly to see how your business is performing.
Net Assets: Net assets = the fair market value of the assets of the organization (investments, fair market value of any land, building or equipment) less the assumed liabilities – or bills that still need to be paid.
Cash Flow: most managers focus on profit when they should be focusing on profit and cash. Factors that affect cash flow are: Accounts receivable – Are your customers paying their bills on time. Inventory – Are you stocking too much and selling or moving some part of that too slowly? Expenses – Do you defer expenses when you can? Do you consider your cash flow cycle when you purchase inventory or supplies? Giving credit – Do you give clients too long to pay their bills? Is it too easy for clients to get credit? Managers who understand cash flow tend to be given more responsibility.
Intangibles: A company’s intangibles are anything of value that you can’t touch or spend: employees, customers lists, patents, brand names, reputation, strategic strengths. They do not show up on the balance sheet except for copyrights and patents which may be amortized or paid over its useful life.
Profit: This is what is left over after expenses are subtracted from revenue. There are three types of profit: gross profit, operating profit and net profit. Gross profit = sales – cost of goods sold or cost of services. Operating profit or EBIT (earnings before interest and taxes) = gross profit – operating expenses. This includes the overhead of running the business where gross profit just reflects the income versus the cost of goods or services. Net profit = “the bottom line” of the income statement. It’s whatever is left after interest expenses, taxes, one-time charges and any others costs are subtracted from the operating profit.
Gross Profit Margin = gross profit divided by revenue
Operating Profit Margin = operating profit or EBIT divided by revenue
Net Profit Margin = Net profit divided by revenue
Capital Expenditures and Depreciation: A capital expenditure is when you purchase a product – a thing – that is considered a long term investment such as office furniture, computers and other equipment, vehicles, buildings. Generally a threshold dollar amount is set so that any purchase over that amount automatically becomes a capital investment (can be $500, $1,000, $5,000 etc.) while anything less is an operating expense. Operating expenses show up on the income statement and therefore reduce profit. Capital expenses show up on the balance sheet. Only a depreciated amount of a piece of capital, a portion of its cost, appears on the income statement rather than the entire purchase being subtracted in one month because that could falsely represent that large expense the company or businesses is doing poorly. By the end of the year it will balance out. The depreciation is accrued, or spread over, the estimated life of the product and is referred to as a noncash expense.
Accruals: An accrual is a portion of a given revenue or expense line item that is recorded across a particular time span instead of in the month it occurs. For instance, you may pay a high software maintenance fee once a year. Instead of reporting that expense in the month the bill is paid, an equal portion of it may be spread out or accrued over a particular time period – often your 12 month budget cycle. The reason for this is to match revenue to costs in a given reporting period – so that at any given time your business does not appear to be in the red when you know it will even out at the end of the year.
If you understand these very basic accounting principles you will better be able to track the deficits and opportunities in your business. Simply accounting software like Quickbooks Pro or Quicken Home and Business will automatically create these reports for you but the reports will do you no good if you do not understand them. Start now!