Why Is it Important to Check Financial Statements?
Revenue is a “vanity metric.” To clarify, this refers to the fact that an increase in revenue does not necessarily denote an improvement in financial health. A business that is earning more and more revenue could still be on the verge of destruction. How much did you spend to earn that revenue? How long did it take for you to receive the revenue? Did you accrue more debt in that period as well?
All of these metrics must be addressed before you can confirm that your revenue truly helped – not hurt – your business. And the only way to find out is by reviewing your financials. Cash flow and profitability are not vanity metrics. When both are in good shape, you don’t have to question whether or not your business is secretly deteriorating.
Here are three other reasons to monitor financial statements regularly:
1. Mistakes Happen with Recurring Bills
Recurring business expenses are usually automatic. You sign up, enter your banking or credit card information, and the transactions occur every month. But mistakes happen, even with the most reputable service providers. A look at your recurring bills might show that your original service agreement does not match up to the amount you’ve been paying. This is why so many people avoid looking at their bills. They already have a feeling that they are paying too much for something. But they don’t want to accept that they now have to spend at least fifteen minutes on the phone to have it corrected. However, business owners aren’t just “people.” If there’s money to be saved, a few phone calls are well worth the trouble.
2. Knowing Which Invoices to Follow Up On
For businesses that revolve around invoices, checking your financials serves as a reminder to follow up on outstanding invoices. These businesses are particularly prone to deception from massive influxes of revenue. They might receive so much revenue at the end of every month that it seems to make up for receiving almost nothing in the weeks prior. But after reviewing their financials, they might discover that some of these invoices are over a month old. And since they arrived at the end of the month, this revenue might immediately be spent on monthly bills. Both circumstances could significantly decrease the profitability of each sale.
3. Small Business Loans are All About Timing
Regularly monitoring your financials is crucial if you consider applying for a business loan or another form of financing. To receive the amount, rates, and terms you desire, you must apply when your cash flow and profitability are in great shape. Businesses often make the mistake of waiting until they need the money to apply. But what if this is also when their profitability or cash flow is on the decline? Once again, you wouldn’t know this unless you reviewed your financials.
Additionally, your financials can tell you the time of the year in which your cash flow is strongest. This may be the best time to take out a loan since the monthly payments would have the least impact on your day-to-day operations.
Now that we’ve established the value of business financials, let’s define each one:
Business Financials: Profit and Loss Statement
The most important financial document for any small business is their profit and loss statement, also called an income statement. It identifies the source(s) of your revenue, your business’s most profitable elements, and every single business expense. This information allows you to create projections, establish a budget, and ultimately determine if your current strategy is genuinely successful. You can also detect trends and discrepancies in performance between specific time frames. And as we mentioned in the previous section, profitability directly affects your access to financing.
It is usually recommended to check your income statement at least once per month. Even though one particular month might feel like any other from this season, the actual data from your income statement may surprise you.
Business Financials: Cash Flow Statement
A cash flow statement is made up of three sections. The first is operating activities, which summarizes the amount of money flowing in and out of your business from sales and the expenses required for day-to-day operations. Any changes involving accounts receivable, inventory, or your business’s actual cash are reflected in the operating activities section. This is where you’ll see how much your business is spending on income tax payments, interest payments, employee wages, and payments made to vendors or suppliers. The second section is investing activities, or the buying and selling of business assets, like equipment. Lastly is financing activities, or how much cash flows in and out of your business due to debt or equity-related activities.
Business Financials: Balance Sheet
The third and final document that makes up a Business Financial Statement, a balance sheet tells you how much your business has and owes. You have your assets (bank accounts, property, computers, etc.) and then liabilities (credit cards, business loans). Adding your assets and your liabilities gives you your total equity. The goal is to have more than you owe and gradually increase the difference between them over time. Another great use of your balance sheet is comparing short-term assets to short-term liabilities. This will let you know if you have enough liquid assets (i.e., assets that can be converted into cash) to cover upcoming payments.
Business Financials: Accounts Receivable Aging
Many business models revolve around invoices. In industries like healthcare, marketing, and wholesale, companies get paid several weeks (if not months) after performing their services or generating sales. An accounts receivable aging report provides a time frame from when an invoice was sent to when it was collected. You can learn which customers frequently pay late when they started paying late, and how much money specific customers owe you.
What Information is on a Profit and Loss Statement?
Since a profit and loss statement is easily the most important of the four, this document deserves significantly more attention. For this reason, let’s make sure you know what you are looking for.
Here are the terms featured in a typical profit and loss statement followed by their definitions:
Revenue
In addition to total revenue from sales, this refers to any money you receive and don’t have to pay back. Possible examples include money you receive from selling equipment or a tax refund.
Expenditures
This refers to the total amount of business expenses. There are other terms on a profit and loss statement that deal with business expenses, but this is the only one that asks for the company’s total.
Cost of Goods Sold (COGS)
The cost of all the resources required for producing a single unit is your cost of goods sold. This includes the cost of materials along with labor. The cost of goods sold is directly related to profitability because a lower cost of goods sold = higher profit margin.
Gross Profit
This section should not be confused with your gross profit margin, which is the profitability of a single product or service. Instead, subtract the cost of goods sold for a single unit from your revenue from a single unit.
For example, if you sell a product for $10 that costs $5 to make, the gross profit is $5. Your gross profit margin, on the other hand, would be 50%.
Operating Expenses (OPEX)
An operating expense is any expense required to run your business that is not included in the cost of goods sold. Examples include payroll, equipment, software, marketing, utilities, etc. Since this list can get pretty big, most profit and loss statements separate operating expenses into different categories.
Depreciation
Depreciation refers to the concept of goods losing value over time. In the small business world, depreciation can affect many equipment types, from landscaping to health care. Business owners keep track of depreciation primarily to write off the losses of value on their taxes.
EBIT
EBIT = earnings before interest and tax. To calculate EBIT, subtract operating expenses from your gross profit margin.
EBT
EBT = earnings before tax. To calculate EBT, subtract COGS, operating expenses, interest, and depreciation from total revenue. EBT is widely used to compare two businesses’ performance, which can be difficult when taxes enter the picture because taxes can vary tremendously from business to business.
Earnings Available for Common Shareholders
This section represents after-tax profits minus dividends from preferred stock. The resulting figure is the cut of the profits available for the business owner and common shareholders since the dividends for preferred shareholders have already been accounted for.
Owner’s Draw
This is the portion of the business owner’s salary that is taken from the company’s revenue.
Net Income
“Net income” is essentially another term for profit. Hence, calculating net income is as simple as subtracting all expenses from total revenue. It’s common for new businesses to arrive at a negative net income or a loss. But if you don’t eventually turn that negative into a positive, your business may be in trouble. Net income is, therefore, the most critical figure in the entire profit and loss statement. Luckily, there is always more you can do to improve profitability.
Subcategories
As you can see, some of the previous categories are very broad. Many businesses break the most general categories into subcategories to create a more granular picture of revenue and expenses. For example, your business might have multiple revenue streams (i.e., in-store and online) or many different materials for making products. In this case, you might want to create a separate category for “materials” and another for your total overhead (expenditures).
Subcategories also make sense when you have a particularly substantial expense that would otherwise be lumped into a broad category. Common examples include rent (instead of lumping this into operating expenses) and shipping (instead of lumping this into the cost of goods sold).
How Do You Prepare a Profit and Loss Statement?
Preparing a profit and loss statement is much easier than analyzing it. Like QuickBooks and Xero, popular software tools can automatically generate financial statements, including balance sheets and cash flow statements. Afterward, all you have to do is run those numbers by your accountant to make sure they are accurate.
Plenty of business owners, however, still prefer to prepare a profit and loss statement manually. This isn’t much of a surprise since you don’t need much information to do so. So, if you’re not comfortable with accounting software just yet, here’s how to prepare an annual profit and loss statement on your own:
- Gather your business’s total revenue from each fiscal quarter.
- Do the same for your business’s expenses. Then, separate each expense into the cost of goods sold or operating expenses.
- Calculate your quarterly or yearly EBIT by subtracting your total expenses from your gross profit.
- Calculate your EBT by subtracting all interest and taxes (over the course of a quarter or a year) from your EBIT. Producing an accurate interest timeline can be difficult. For that reason, it might be safer to have your accountant or finance professional calculate this number for you or make sure it is correct.
- Now that you’ve gathered the essential figures for your profit and loss statement, the final step is to calculate your net income. After all, this document’s primary purpose is to determine if you are operating at a profit or loss.
Who Prepares Your Financial Statements?
Traditionally, it was your accountant’s job to prepare financial statements. Today, however, many businesses are comfortable leaving this responsibility to their bookkeepers.
The terms “bookkeeping” and “accounting” company interchangeably. This is confusing but understandable. The jobs of a bookkeeper and an accountant are very similar. Both of them help small business owners manage their finances. Both of them tend to work together towards the same goal. But small business owners need to know the differences between the two. This will determine whether your current needs call for a bookkeeper or an accountant. What expectations should you have for each individual? Your business may need to rely more heavily on a bookkeeper, whereas an accountant might be instrumental to another business’s growth.
Before explaining what sets them apart, let’s go over the essential tasks associated with each occupation.
What Does a Small Business Bookkeeper Do?
Bookkeepers traditionally deal with day-to-day financial records. These are commonly referred to as a business’s “books.” A bookkeeper’s primary responsibilities include recording financial transactions, updating spreadsheets, and processing payroll. At the end of the month, bookkeepers reconcile bank statements, which means comparing bank statements to your financial records. After identifying and resolving any discrepancies, the bookkeeper produces monthly financial statements.
Since record-keeping is the bookkeeper’s central task, bookkeepers usually have their record-keeping method, along with their preferred software. It’s up to the bookkeeper to familiarize the business owner with their processes to ensure a trustworthy relationship.
While these are a bookkeeper’s traditional responsibilities, many bookkeepers perform additional tasks. This includes manually sending invoices, implementing automated invoicing systems, and manually paying the business’s monthly bills. Bookkeepers who have worked with a company for several years typically have a firm understanding of the business’s finances. Thus, they may provide general financial advice and forecasting.
What Does a Small Business Accountant Do?
These days, small business accountants focus more on financial strategy. The only documents they prepare are financial statements and reports for banks and government agencies, like the IRS. Your accountant files your business tax returns, tells you how much money to put away for tax season, and keeps you informed regarding new tax laws and deductions.
Aside from tax planning, most of their job involves using the documents prepared by bookkeepers to draw meaningful conclusions about the business’s financial health. Small business accountants tell business owners what to change about their spending habits and identify the most detrimental areas to profitability. They also explain how to pay for different expenses (credit cards, savings, etc.) and help business owners manage debt in general.
This makes accountants extremely valuable when the time comes to seek additional business funding. Accountants can tell you which tools (business term loan, business line of credit, short-term business loan) are most sensible for the investment at hand. They’ll explain when to apply for funding, how much money to request, and what kind of terms would be best for your cash flow. Several calculations can answer these questions, and it’s the accountant’s job to perform them. A good accountant can be the underlying difference between a business that achieves sustainable growth and another one that tries to grow too quickly or overlooks the root of its cash flow problems.
How Do You Know If You Need a Bookkeeper or Accountant?
The standards for what constitutes a good bookkeeper or accountant have increased as of late. Today’s bookkeepers do a lot of things that were previously only reserved for accountants. This is mostly due to advanced technology that streamlines the bookkeeping process. Bookkeepers now have the time to offer advice for improving your financial health or simply maintaining a budget. Accountants used to be the go-to people for information because they have more education under their belts. Becoming an accountant does require more academic schooling than becoming a bookkeeper. Much of the knowledge taught to accountants, however, is now freely available online.
The increasingly advisory role of bookkeepers is likely one reason why accountants have expanded their responsibilities. According to the traditional definition, a small business accountant is technically obligated to assist with business finances. But when you work so closely with someone, the line between business and personal finances begins to blur. Small business accountants are now more knowledgeable about their clients’ personal finances as well. They might offer advice for shielding your personal finances from the ups and downs of your business’s finances or using your income to build your retirement fund.
3 Things To Remember When Hiring a Bookkeeper or Accountant
But while specific responsibilities may vary from business-to-business, both roles are undeniably important. For this reason, you should choose your bookkeeper and accountant very carefully. The ability to completely trust someone with financial advice and accurate bookkeeping is an invaluable resource. Some business leaders would even say it’s mandatory for success.
Here are a few tips for choosing an accountant or bookkeeper:
Think Twice Before Hiring A Spouse Or Friend
It’s not uncommon for small business leaders to put spouses, friends, or relatives in charge of their books. Yes, this is much cheaper than hiring a professional, and you already know the individual can be trusted. But small business accounting requires a very particular skill set. Someone who knows how to monitor debt and organize paperwork won’t necessarily be a good small business accountant. Besides an expansive knowledge of small business tax laws and business finance laws, you need someone with experience in planning financial goals and developing spending strategies. And there’s a lot more documentation to keep track of, like bills, invoices, or proof of payments.
So, before hiring someone you already know to do your books, consider if this is truly a wise decision. There’s probably much less risk in confining this person to something more rudimentary, like payroll. Determining why you need a professional in the first place is crucial for choosing an accountant, which segues into the next section:
Lay Out Everything You Need Beforehand
Before starting your search, you must lay out everything you expect in a small business accountant. Chief among your requirements will likely be trust, which makes sense due to the sensitivity of the information at hand. You are right to feel nervous about handing this information to a stranger. If you don’t feel this hesitation, you might end up hiring the wrong person to get this process over with. Different accountants have experience in different areas. To determine what kind of accountant you need, think about what this person’s primary responsibilities will be or which problems you’d like this person to spend the most time solving.
For example, your company might be looking to reduce wasteful spending or improve structure. Accountants can also develop a plan if the business fails to meet its revenue goals on time or a crisis compromises the majority of your operational budget.
Even A Temporary Accountant Can Be A Huge Help
A younger or smaller business might not have the funds to hire a full-time accountant. The business might be highly seasonal, so it wouldn’t make sense to keep an accountant on staff for 12 months a year. But this doesn’t mean you shouldn’t hire an accountant at all. A temporary or part-time accountant could still be extremely beneficial, especially for the busy season. Some businesses hire accountants on an as-needed basis since it allows them to expand their role as the business grows gradually.
A major turning point of this process may be deciding whether to work with an accounting firm or hire an in-house employee. Though smaller firms have lower fees and personable staff, they are often paid by the hour. These fees can get very high for a growing business, so it is typically recommended to choose an in-house accountant.
Do All Businesses Need Bookkeepers and Accountants?
All businesses are recommended to hire an accountant as soon as they open their doors. But since the business is still small, you will likely be able to handle bookkeeping yourself. The moment a business becomes so busy that it is forced to hire a bookkeeper is a monumental point in its journey. This is when you are finally ready to serve more customers and take on a higher competition level. Both of these aspirations will likely require substantial investments. Those investments are much easier to achieve with the help of both an accountant and a bookkeeper.
