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  • Being Accountable: Budgets, Books, and Statements
    Game Plan
    In-Depth

    Your First Financial Statement

    For many people, the term “financial statement” conjures up the tables of data that appear near the end of annual reports. While it’s true that publicly traded companies are required to “open their books to shareholders” in annual 10-ks and quarterly 10-Qs, financial statements play an important role in planning long-term strategy and tactical spending decisions for business owners and managers throughout the year.

    The U.S. Securities and Exchange Commission (SEC) requires public companies to provide three specific reports: the balance sheet, the income statement, and a cash flow report. In discussing financial statements for emerging businesses, some sites, such as the SBA’s, discuss only the first two. Other advisors insist that the cash flow report may be the most important of all, because a company could have a healthy balance sheet but still have to shut its doors because it didn’t have enough cash to pay its current bills.

    Let’s take a quick look at what the different reports can show you.

    Balance Sheets
    The balance sheet is comparable to a net worth report for an individual. It lists assets first and then liabilities. The report’s structure can be a bit confusing at first because net worth (or equity) is included with liabilities. Shouldn’t equity be an asset?

    Actually, some simple algebra clears this up in no time. Since assets minus liabilities equals net worth (A-L=NW), then assets are equal to liabilities plus net worth (A=NW+L). Framing the relationship in this form is essential in accounting terms, because both sides of the ledger have to balance out. Thus the name—balance sheet. The SBA website offers this practical explanation within this article: “Liabilities and net worth on the balance sheet represent sources of funds… Liabilities represent obligations to creditors while net worth represents the owner’s investment in the business. Both creditors and owners are ‘investors’ in the business with the only difference being the timeframe in which they expect repayment.”

    To create a balance sheet, you’ll pull in numbers from your general ledger. Assets will include current assets, such as cash on hand, receivables, and inventory, and fixed assets such as land, buildings, machinery, equipment, and furniture.

    Liabilities will include current liabilities, such as accounts payable, wages, payroll taxes, employee benefits, and short-term debt service. They’ll also include non-current liabilities, which are basically loans that are not due within 12 months, plus equity, which is the owners’ stake invested in the company.

    Income Statements
    The income statement, also known as the profit-and-loss statement (P&L), lets you review your company’s financial performance over a specific time period—and compare it to prior periods. The format is comparable to a budget, but showing only the actuals, not the estimates. And the categories are restricted to high-level roll-ups, so you can easily see the big picture.

    A typical P&L starts with top-line revenue, which is simply your income for the given time period—whether it’s a year, a quarter, or a month. Next you subtract the cost of goods sold, which has three categories: inventory, purchases, and labor (to produce the product or service). The result is your first big subtotal, called gross profit.

    Next you subtract operating expenses, which include the costs of sales, marketing, and general administration. The result is your operating income. From here, you can take two more subtotals—subtracting interest expense on loans and taxes. And you arrive at your net profit, which is literally the bottom line of the P&L.

    Cash Flow Reports
    The cash flow statement is basically a year’s worth of checking account statements, captured on a one-page spreadsheet. The top line is the cash on hand at the beginning of the time period—let’s say it’s the month of January. The next rows are headed “cash receipts.” The spreadsheet can have as many lines here as are needed to capture all sources of incoming cash.

    Next follows a section of rows categorized as “cash paid out.” Included are all the familiar categories of business expenses—cost of materials, wages, payroll expenses, rent, utilities, taxes, interest, etc.

    For convenience, you can also include another section called “other operating costs.” These rows could capture non-recurring cash expenses like purchasing capital equipment, cash draws by the owners, or transfers to a reserve account.

    From here it’s simple addition and subtraction. Start with cash on hand, add the income, subtract the expenses, and the total is the month-end cash position. Copy that number to the top line of the February column and repeat this process for the rest of the year.

    The benefit of the cash flow statement is that you can quickly scan across the top line to get a quick sense of how your business is faring. You can also look for trends in total cash receipts or total cash paid out. If you spot a problem—or a welcome surprise—you can then scan across each row to try to pinpoint the source. That’s a lot of powerful information from a one-page spreadsheet.