Wednesday, November 23, 2022

Financial Statements 101

If you want to operate a business, then you must understand the financial status of your company. You should also know your company's financial projections. In this article, we introduce you to the basics of financial statements.

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The Importance of Financial Statements

Starting a company can be tough. If there’s one area many founders struggle with, it is the financials. Your bookkeeper and accountants will be in charge of crunching the numbers. However, the buck stops with the directors who must monitor the company’s financials as they are ultimately responsible.

You will also need to make critical business decisions based on the company’s financial reports. Additionally, if you would like to get finance at some stage, the bank will need to look at your company’s financials.

Investors will also place a great deal of importance on the state of those financial statements. Having your financials in order is essential to show keen investors that you are responsible, and they can trust you not to waste their money.

If you are considering selling your company, it is another reason it is crucial to have proper financials in place. The buyer will want to look at your books as part of their due diligence process. As with other lenders, banks also care about how well financials are maintained, and many assess unmaintained financials as a risk.

Let’s take a look at the various types of financial reports that you must be familiar with and discuss their function. There are many types of financial statements that may be generated. Below, we will discuss the basics of the most important. Sound boring? I don’t think it is. Once you begin to make better business decisions based on your company’s data, I guarantee you will feel more empowered and confident. An entrepreneur who understands these aspects will have an advantage over those who avoid developing their financial literacy.

Bookkeepers and Accountants

A bookkeeper or accountant can help you set up these reports in Xero or MYOB. The bookkeeper will input the data required to generate the financial reports. Although you should focus on running your company rather than burying yourself in data input, you will need to understand the reports. This will allow you to make intelligent business decisions. Let’s take a look at some of the most important financial statements you need to understand.


Financial Statements 101

Profit and Loss Statement

The profit and loss statement shows where the company’s finances have been over any given date range. Also known as the income statement, the profit and loss statement (P&L) contains the following five sections:

1. Revenue

2. Cost of Goods Sold (COGS)

3. Gross Profit

4. Expenses

5. Net profit

At the top of the income statement, you will find company revenue. After revenue, the income statement will list how much it costs to make your products or services. This is referred to as costs of goods sold – or COGS. These costs include the material, labour and other costs of creating your product. By subtracting the cost from the revenue, you will get to the part of the income statement, which will show your gross profit.

One thing that investors will ask you right away is your profit margin. A product that costs one hundred dollars to produce and sells for two hundred dollars will have a profit margin of fifty per cent.

Next is the operating expenses of the business. Included in this section are your marketing, research and development (R&D), and other expenses. Phone lines, office equipment, leases and anything else that your business spends money on are listed here.

Operating Profit is also known as EBIT, which stands for Earnings Before Interest and Taxes. You must know your EBIT because your startup’s valuation will relate closely to it. The valuation is vital if you decide to sell your startup or get investors to invest.

It is common for company managers to get into trouble because while they may be positive and experiencing a tremendous net profit, upon later subtracting taxes, loan payments and other expenses, they realise their company actually has a negative cash flow.

Here’s how your P&L is used to calculate the various numbers that you must know: 1. Gross Profit = Revenue COGS 2. Gross Profit – Expenses = Operating Profit. 3. EBIT + Other Income = Net Profit.

Cash Flow Statement

The cash flow statement will show how much income is coming into your company and how much you are spending in a given period. The cash flow statement will be a good depiction of the amount of money the business made after all expenses are paid. Cash flow statements have three categories. They are operations, financing and investing. The cash flow statement is broken down in these areas to allow you to see where the money is flowing.

The operations section relates to your core business activities, such as selling your core product. The financing section shows money flows as a result of loans that have been taken or are being repaid. Whereas, the investing section indicates money that is being spent on property and equipment for your startup. Ensure your income from operations remains high – especially your cash from sales.

You should also minimise accounts receivable, which are monies owed to you. Busy entrepreneurs must be aware of where their accounts receivable and many companies tend to leave unmonitored for too long. It kills cashflow and can potentially make founders appear unprofessional when they have to continually chase-up monies owed to them.

Balance Sheet

At the foundation of your financial architecture, you will find the balance sheet. If you’re a fan of Robert Kiyosaki, you may have seen the illustration where he lists the assets and liabilities in two simple columns. Your company’s assets minus the company’s liabilities provide you with the fundamental status of the financial health of your startup.

Assets can be cash in company accounts, accounts receivables, IP, goodwill, inventory, equipment, property, and anything that adds financial value to the company. On the other hand, liabilities are the items that cost the company money. These can be loans, payables (money that you owe others).

Liabilities also include equity that your startup owes to shareholders, annual leave entitlements, salaries, and other expenses. The balance sheet not only shows assets and liabilities; it also provides a business owner with an overview of the equity of the shareholders. You can think of a balance sheet as a snapshot of how your company is doing financially. Does it have more money going out than coming in?

The balance sheet must be updated and reviewed at the end of each month to ensure that the company stays on track. The balance sheet will also provide retained earnings. This is the net profit that the company has after paying shareholder dividends.

You will also be able to keep track of any company losses in the balance sheet that may have been carried forward from previous periods. This may seem far too fundamental to state – but I have to say it. Make sure that your balance sheet actually balances. I

know, I know – you may think this goes without saying. However, company owners don’t always check. This is a reminder that merely generating statements is not enough. Make sure you understand the figures and why you are creating these statements and how they correlate to each other.

Operating Budget & Forecasting

The operating budget involves creating a plan to utilise funds in the best way possible to achieve your company’s future goals. Likewise, you must meet your expenses when considering your budget. Similar to budgeting, forecasting determines how your business will do one, three, five, and even ten years into the future. Forecasting requires basing your decisions on historical data. Although early-stage startups don’t always have the data to be able to do so.