Recently I was asked about financial statements, so I thought I’d put my answers to the 4 most important questions I answered in this post.
1. What is the purpose of financial statements? Why do they matter?
Financial statements are critical in understanding the financial health of your business, in forecasting future results and in goal setting.
With regards to financial health, your financial statements tell you how your company is performing and how much cash and/or current assets your company has to ensure you don’t run out of money.
With regards to forecasting future results, creating forward-looking financial statements (financial projections) helps you see where your business might be in the future…be it 6 months from now or 3 years from now.
In the same vein, creating forward-looking financial statements allows you to create goals for your team to accomplish. For example, you can set sales goals to organize and motivate your team and use the financial statements to see if your team has met the goals or not.
2. Which do you think is most important for small business owners? (Balance sheet vs P&L vs cash flow)?
I think that Income Statements (P&Ls) are most important for small business owners since they tell them if their business is profitable or not. Generally profitable businesses will survive in the long term.
That being said, Cash Flow Statements and Balance Sheets are crucial in showing small business owners their cash balances, and this is a critical metric….because there are cases of profitable businesses running out of cash.
The classic example of this is a company selling products to a large retailer who doesn’t pay them for 120 days. While the company can be very profitable on paper, they could run out of money and go bankrupt during the 120 days they are waiting to receive payment.
A company’s forward-looking/projected Cash Flow Statements and Balance Sheets would alert the business owner to this upcoming problem and allow them to get funding (bank loan, increase credit card limit, etc.) in advance of the problem.
3. What advice would you give to business owners, new to financial statements?
Financial statements look very scary at first. They include lots of information and is hard to read/interpret when you don’t know what to look for.
As such, start slowly. In your Income Statement, start by just looking at Sales, Expenses, EBITDA (earnings before interest, taxes, depreciation, and amortization) and Net Income. These figures should make sense to you.
In your Balance Sheet, just look at your Cash, Accounts Receivable and Debt. These figures should also make sense to you.
Finally, in your Cash Flow Statement, just look at your Net Cash Flow and Cash at End of Period.
By starting with just the metrics that are most important and easy to understand, you will get value from reviewing your financial statements. Over time, as you get comfortable reviewing them, you can learn more about the other line items in each statement.
4. How do you recommend they build them? Should they use an accountant, Quickbooks, what approach is most common?
QuickBooks will automatically generate your historical financial statements. However, as stated above, forward-looking/future financial statements/projections are even more important.
For these, I recommend using a spreadsheet like Microsoft Excel or Google Spreadsheets. By using spreadsheets, you can easily test assumptions.
For example, you can quickly see the effect on each of your financial statements (Income Statement, Balance Sheet, Cash Flow Statement) of sales increasing 2% or decreasing 1%, or hiring a new employee for $50K vs. $80K/year. This allows you to better plan and prepare for the future.