SMB Financial Fundamentals: Understanding Financial StatementsFeb 08, 2024
Today I'm going back to the basics, with a sneaky little announcement, too.
Understanding Financial Statements is the foundational skill required to understand the numbers behind your business.
But too many business owners don't commit the time to doing so.
Today we're going to start a series on the basics of financial analysis.
But first, our sponsor.
A message from Sidebar
Accelerate your career
10+ years ago, I felt like I wasn’t living up to my potential in my career. I realized I wasn’t surrounded by the right people. I reached out to a friend and mentor and found a small group of peers who pushed me to grow and level up my skills. It was transformative and resulted in me starting my own business.
That is why I was so excited when I found out about Sidebar.
Sidebar is a leadership program that accelerates your career.
When joining Sidebar, you get matched with a small peer group who help you track your goals, stay accountable, and increase your growth. On top of it, you get curriculum that helps you level up your skills.
The right people around you is an untapped competitive advantage. Sidebar is that competitive advantage.
And the impact is tangible: 93% of members say that Sidebar has made a significant difference in their career trajectory.
You could go your whole career never finding the right group to help you grow. Sidebar gets you there faster.
|Request invite to join
Want to advertise to 40,000 small business owners and leaders? Go here.
SMB FINANCIAL FUNDAMENTALS: UNDERSTANDING FINANCIAL STATEMENTS
48% of small business owners say they don’t understand their financials.
50% of businesses fail in the first 5 years.
82% of failed businesses have cash flow problems.
It’s clear, especially in SMBs, there is a financial literacy problem.
And honestly, it’s not surprising.
As a business owner, you’re supposed to have it all together. It takes a setting aside your pride to admit you don’t understand something as fundamental as your numbers.
But the problem is, the same people who excel at starting a business are the same people that are most likely to not understand their financials.
Starting a business requires a bit of a “figure it out” mentality, so financials are approached with that same mindset.
This sounds good, but there is a big problem with this approach: it works until it doesn’t.
It starts with you watching the bank account. You see the monies go in and out and you get a good sense for how things are flowing.
This gives you confidence that you understand your business… and you do.
But living and dying by the bank account can, and will, backfire.
It’s only a matter of time and if that’s all you’ve ever done you’ll feel lost and helpless.
I don’t want to paint a stark picture, but it’s the reality.
And sometimes it’s not even your fault. I’ve seen business owners bring on advisors who were supposed to know the answers but ended up in over their heads, too.
I’ve seen those who made it work, but market conditions surprised them and they couldn’t react quickly enough.
I even felt overwhelmed about translating financials in my first job in a small business. I share about this in my 7-day email course on financial statements, which you can subscribe to by clicking here.
Today, I want to introduce you to the basics of financial statements. Then, over the next 4 weeks, I’m going to be going deep into financial statements:
- Revenue & Profit Drivers
- Cash Flow Drivers
- How to identify and track your key metrics
- Translating numbers to business decisions
The goal of these next 5 weeks (including today) is going to be setting a foundation of financial analysis that will transform the way you think about your business financials.
Back in December we briefly intro’d the drivers concept, but we’ll go a bit deeper over the next few weeks.
Then we’ll discuss how to identify the right key metrics for your business, then develop a mechanism to track them (and on what schedule).
Then last, we’ll help you establish criteria for using the numbers to inform business decisions.
This is, in a way, a preview of what is to come with my cohort, which I’m relaunching March 11th. I’ll be sharing more about this over the coming weeks, so be on the lookout.
Each company has 3 financial statements and they answer different questions:
- Income Statement (Are you profitable?)
- Balance Sheet (Are you healthy?)
- Statement of Cash Flows (Where is cash going?)
The way the 3 statements are represented is based on the type of financial you’ve run: cash or accrual basis.
We don’t have the space to do a whole masterclass on cash vs accrual, but I’ll likely do that in the coming months.
Cash is just like it sounds… cash in and cash out. When you look at a cash basis Income Statement, the following is true:
- Revenue = cash received for service/product
- Cost of Goods Sold = cash paid out for product
- General Expenses = cash spent or credit card being charged
With Accrual Basis Financials, the goal is to match revenue and expense to get a true look at profitability.
- Revenue = work done/invoiced for service product
- Cost of Goods Sold = cost directly associated with Revenue
- General Expense = work done/billed
As an accounting guy, I love a good accrual financial, but they may not be right for all businesses. The reality is, accrual financials are more complicated, and simple businesses might be better off sticking with cash.
Revenue - Expenses = Profit
The Income Statement is typically what businesses primarily look at. It’s a great statement that shows “profit,” which gives you a sense of how healthy the business is.
Revenue is money from sales of product or service.
Expenses, at a high level, are broken into:
- Cost of Goods Sold
- Operating Expenses
- Non-Operating Expenses
When analyzing an Income Statement, there are many things you can be looking for. Today I want to focus on two types of analysis:
- Vertical: compare to expected values
- Horizontal: compare to historic values
Vertical analysis is comparing each number to a baseline, like a budget or as a percentage of revenue.
Horizontal analysis is comparing each number to previous values. It’s understanding how current values relate to previous and if they’re in line with expectation. This helps highlight how spending has changed in the business, whether for better or worse.
Some other things to consider:
- What are your product/service costs as a percentage of revenue? Cost of Goods Sold (COGS) is one of the most important numbers out there and can be a substantial portion of overall expense. Knowing how to manipulate COGS is key to knowing how to manipulate your cost.
- Payroll Expenses: payroll directly relates to people, which means it’s always important. It’s also one that’s hard to reduce, so you have to watch it carefully.
- Profit: this is THE number, especially with accrual financials. Understanding where your profit is in relation to your industry peers and making sure you’re generating enough cash to pay for the items on the Balance Sheet are key.
Assets = Liabilities + Equity OR Assets - Liabilities = Equity
The Balance Sheet is a powerful statement that is often overlooked by the amateur.
But the Balance Sheet is actually the TELL ALL statement out of all 3. That’s because, if you include changes from previous periods, it includes all the elements from the Income Statement and Statement of Cash Flow in it.
Retained Earnings, which is in the equity section, includes current year and previous year earnings (or profit). Profit is the bottom line result of the Income Statement, which means that the Income Statement is an expansion of one line on the Balance Sheet.
Sure, we need the Income Statement. But if you would only give me one, I’d choose the Balance Sheet.
So, what does the Balance Sheet do? it gives us a snapshot of the company’s health and financial strength at one point in time.
It’s broken into 3 categories, which are generally self-explanatory:
- Assets: what you own
- Liability: what you owe
- Equity: book value of company
In the same way you can use vertical and horizontal analysis on the Income Statement, you can use it on the Balance Sheet.
But let me add one more to the mix (which works on the Income Statement too): KPI Analysis
KPI stands for Key Performance Indicator and is just that: what key metrics drive the results in your business?
When looking at the Balance Sheet, we’re trying to determine the health of the business. Here are a few things to look at:
- Cash balance: having a healthy cash balance helps a business stay healthy. The amount of cash you need depends on the business, but understanding your minimums and the trend is key to staying on top of cash health.
- Current Ratio (Current Assets / Current Liabilities): this measures your ability to pay obligations due within one year. When it remains above 1 that is a signal of health, but when it gets too high it means you’re using capital inefficiently.
- Debt-to-Equity Ratio (Debt / Equity): when debt is greater than equity (a number greater than 1), it could be a sign you have too much debt in the business. Compare yourself to industry peers to see how you’re doing.
- Return on Equity (Net Income / Shareholder’s Equity): this is of the “return on” ratios (ROA, ROIC, & ROCE) and which one you use will depend on your specific situation. Ideally you should be getting returns greater than what you could get outside the business, as our goal should always be to maximize returns.
- Debt Service Ratios: There are many of these and what’s important depends on your situation. These are key when looking
Statement of Cash Flows
Net Increase/Decrease of cash during period + Cash at beginning of period = Cash at end of period
This is the least used and least understood statement. The Statement of Cash Flows reflects how cash has moved through the business over a set date range.
I compare it to looking at a bank statement.
You have a beginning balance, then have each transaction. It’s like if you categorized each transaction by what type of transaction it was. The statement is broken into 3 sections:
- Operating Activities (changes related to day-to-day biz)
- Investing Activities (purchase or sale of assets)
- Financing Activities (changes in debt and capital structure)
The changes in cash tell you if the business generated cash or “ate” cash during that period and what categories that cash movement fell under.
The key numbers when looking at this statement are Operating Cash Flow and Free Cash Flow.
We want to be able to generate enough money from operations to fund reinvestment (investing in assets), debt paydown (financing activities), and distributions to owners (financing).
A business that isn’t able to fulfill these 3 functions is a business that’s on the path to failure.
This statement isn’t super imporatnt with Cash Financials, as this activity can easily be extracted from the Income Statement and Balance Sheet. But, when looking at Accrual Financials, this statement becomes VITALLY important.
When doing Fractional CFO engagements, I ask for a “normal” set of financials the company looks at and I’ve never been provided a Statement of Cash Flows, even for businesses on Accrual.
By not preparing it, you’re blind to the bank account swings in your business and potentially missing your true cash flow from operations. Relying on profit to understand this isn’t sufficient and can be highly misleading.
Today was setting a foundation for the weeks to come. I encourage you to really internalize these fundamentals, as they’re what everything else is based on.
If you’d like to get better, I’d encourage you to seek out financial statements from other businesses and see how well you can read them and extract value.
Next week we’ll talk about the “drivers” that determine business results and how you can determine what these are for your business.