Finance and accounting are topics that many small business owners dread, but a better understanding of them can help you spot what’s going well and what needs improvement in your business.
Learn these key principles and you’ll more effectively manage your business, despite the fear that comes with spreadsheets and pages full of numbers.
Income statement, cash flow statement and balance sheet
The three types of statements that all business owners need to know are the income statement, cash flow statement and balance sheet. Together, these statements make up the majority of accounting information that affects your business.
Income Statement: The income statement is the one that many small business owners are most familiar with. It shows all sources of sales revenue and all operating expenses, and the difference between them (profit or loss) over a specific period of time (such as monthly, quarterly or yearly).
Cash Flow Statement: As its name suggests, the cash flow statement focuses on cash. It includes what’s in the income statement from sales or services, and adds in many other sources of cash that aren’t included in the income statement, such as investment income or interest. The cash flow statement also disregards certain expenses that don’t necessarily involve cash or directly impact cash on-hand. The cash flow statement is most important to new and young companies because it shows a more honest and comprehensive picture of a company’s health.
Balance Sheet: Simply put, while the income statement and cash flow statement show what’s happened in your business, the balance sheet shows the results of what’s happened. If you make money over a certain period of time, the resulting amount of cash shows up in the balance sheet. If you borrow money over a certain period of time, then the resulting debt shows up on the balance sheet. There’s more to the balance sheet and your bookkeeping software or your accountant can help you learn more, as can this free online tutorial from SCORE. But, if you understand the basic relationship, you’re already ahead.
Cash and accrual accounting:
The two ways that financial activities are tracked are cash basis and accrual basis. Cash basis is what most of us are familiar with – when your business gets paid, it counts as revenue in the income statement. When your business pays a bill, it counts as an expense.
The more advanced alternative is accrual basis. In this method, transactions are counted when your company earns income and when it uses the value it derives from expenses, which may not always align.
Here’s an example: A caterer takes a deposit of $500 for a wedding that will take place a month from now. If the caterer is using cash basis, he or she would record the revenue earned on the day the deposit is received. But in cash basis, the fact that the caterer still has a responsibility, and expenses, to cook and prepare for the event a month from now is not represented on the income statement.
In accrual basis, the $500 deposit isn’t counted as revenue until the work is completed (income earned).
Your choice between cash and accrual basis comes down to this: cash basis is easy to implement and works in many situations, but if you find that there is a substantial gap between when your company earns income, pays for expenses and gets paid, then for planning purposes, it might be worthwhile to switch to accrual basis.
Receivables, inventory and payables:
For businesses that use accrual-basis accounting, these terms, collectively, represent money the business owes and money the business is owed. Knowing them helps you better manage operations:
- Receivables: Accounts receivable (or, simply, receivables) represents the value of work that has been completed and billed, but has yet to be paid. The balance of receivables tells how much money you should expect to be paid soon.
- Inventory: Inventory is the value of goods (either materials or completed goods) that the business has acquired but has yet to sell. (When inventory is sold, it becomes an expense known as cost of goods sold, or COGS). Inventory can tell you many things, like when it’s time to reorder or how well the company selects materials or products. Inventory levels are also early indicators of potential growth or decline in future sales.
- Payables: Accounts payable (or, simply, payables) is the value of goods or services that the company has used but has yet to pay for. Should you be lucky enough to get credit from your vendors, payables are a great way to manage your business’s cash flow. More fully utilizing the payment terms that your vendors give to you helps to free up cash for the rest of your operation.
One of the most common problems facing small businesses is that they often don’t have sufficient working capital – essentially, cash on-hand that’s available to pay for the cost of ongoing operations like rent, payroll and utility bills. Here’s an interesting point, too: Startups need two types of working capital. First, there’s temporary working capital to fund losses accrued until the business breaks even. Second, there’s a residual amount of permanent working capital needed to fund ongoing operations.
To find out how much working capital you have, look at your balance sheet. Find the figure for “Total Current Liabilities” and subtract it from “Total Current Assets.”
“Retained earnings” is basically the “magic number” that makes the balance sheet balance (in other words, it’s the number that makes total assets equal to total liabilities plus total equity). It represents the net value of all profits that have been kept in the company (versus paid out), since inception. Together with the total amount of cash that business owners and investors put into the business, this represents the value of all equity-owners’ stakes in the business, if the company were to shut down, sell all assets and pay all debts. If a business has negative retained earnings, it means that it has been funding losses by securing new investments or debt.
Profit margins are expressed as percentages and are figured by dividing profits by the amount of revenue in the same period. They give an apples-to-apples comparison of different profit figures to help gauge how “good” or “bad” they are. For example, while $10,000 of annual net profit might be extremely good for a company making $50,000 in annual revenue (a 20 percent profit margin), it would be quite low for a company making $1 million per year (one percent). In contrast, a 10-percent net profit margin has the same meaning for companies of any size.
Two key profit margins include:
- Net profit margin: Sometimes referred to as “the bottom line,” the net profit margin is a measure of how effectively a company turns sales of goods or services into profits that can be used to pay owners or investors, or alternatively, the number of cents of every dollar of sales that becomes profit for owners or investors.
- Gross profit margin: The gross profit margin is a measure of how effectively the business’s sales cover the direct costs associated with the business (like inventory and materials). The gross profit margin also tells how much money is available to cover remaining expenses to break even. The gross profit margin can also be used to calculate monthly break-even sales volume by taking monthly operating expenses and dividing them by the gross profit margin.
With these accounting principles in mind, you’ll be able to better chart the course of your business and make improvements to its operations over time. Have additional questions? The Business Advisory Services team at EGF is here to help.
About Excelsior Growth Fund
Excelsior Growth Fund (EGF) helps businesses in New Jersey, New York and Pennsylvania grow by providing streamlined access to business loans and advisory services. EGF’s signature product, the EGF SmartLoan™, provides up to $100,000 in fast, transparent, and affordable financing through a secure online platform. Larger loans up to $500,000 are also available. EGF is a nonprofit organization and is certified by U.S. Department of Treasury as a Community Development Financial Institution (CDFI). Learn more at www.excelsiorgrowthfund.org.