Financial statements and your business

Many small businesses operate on a cash basis, and the extent of their financial reporting is a monthly bank statement. At the end of the year, they pull all of their receipts together and group them so that they can complete their tax forms. That is a tough way to run a business because it is difficult for business owners to keep track of their financial position without good financial statements.

Why do you need financial statements?
Financial statements tell the story of a business. Income statements tell the story over time. Balance sheets tell the story at a point in time. Business owners want to know if they are making a profit and if they are going keep making a profit. Financial statements can help answer those questions. At some time or another, business owners will want to tell this story to others as well.

• Investors
• Suppliers
• Customers

Investors want to know if they are going to be paid back. Suppliers want to know if you will be around as a customer. If you are, how they want to know how big a customer you might be, and they want to know if you can afford to pay for their goods. Customers want to know if you are going to remain in business. If they buy products from you, they want to know that you will be able to stand behind them. If you provide some sort of professional service, they want to know that they will be able to go to you in the future.

Why not have financial statements?
Some small business owners have the misperception that it is too difficult or too expensive to maintain the records necessary to produce financial statements. Fortunately, keeping good financial records is actually fairly simple and not very expensive. Business owners can use spreadsheets such as Microsoft Excel, or they can use bookkeeping programs such as QuickBooks. Templates are available for spreadsheet users. Businesses that opt for bookkeeping software will even find that the software grows with them. The cost of these programs can be under a couple of hundred dollars. Business owners can also hire bookkeepers to do the work for them. This is also less expensive than many business owners realize, and having organized records and financial statements will reduce the cost of tax preparation. It can also make it easier to obtain financing.

Basic Statements
However you keep your records, you should produce these statements.

• Balance Sheet: This is a snapshot of short-term and long-term assets and liabilities.
• Income Statement: This is commonly called a P&L or profit and loss statement. It begins with revenue and then shows the effect of various expenses and ends with net income.
• Statement of Cash Flows: This is a description of how cash flowed in and out of your business, and it describes generally where money came from and how it was used in terms of operating, investing, or financing activities.
• Statement of Retained Earnings: This is a statement showing the accumulated earnings of a business.

Financial ratios
Once you have your financial statements in hand, you can review them. A few of the common ratios typically used to evaluate businesses are listed below. The list is far from complete. For example it does not include activity measures such as conversion periods or turnover ratios.

Measuring profit
Gross profit margin: This is a measure of how much of your income can go towards overhead and profit.

Gross Profit / Net Sales

or

(Net Sales – Cost of Goods Sold) / Net Sales

Operating margin: This tells you the profitablity of your core business.

Operating Income / Net Sales

or

(Operating Revenues – Operating Expeneses) / Net Sales

Measuring Liquidity
Current ratio: This is a measure of your ability to pay short-term debt.

Current Assets / Current Liabilities

Quick ratio or "Acid Test:" This is a more stringent variation of the current ratio. The Acid Test compares current assets net of inventory to current liabilities.

Evaluating Debt
Debt to assets ratio: This measures how much you rely on borrowing to finance operations.

Total Liabilities / Total Assets

Times interest earned or Interest coverage: This ratio measures the relationship between your income and your interest expense.

Net income / Interest Expense

Debt service coverage: This ratio shows the relationship between your operating income and your debt service expense.

Net Operating Income / Debt Service