Wise Wizzard Words

Why does it seem that financial statements are written in a foreign language?

You went into business because you were passionate about what you do, or just good at it. You want to make money, too.
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But your financial results from your accountant are hard to read. In fact, some entrepreneurs avoid looking at their financial statements because they don’t know how to read them. Spending a bit of time understanding your financials can give you the insights you need to make real-time business decisions that help you reach your goals.
 
Your financial statements are likely to contain several different reports, details that give you information about the business. The first report is the balance sheet, also called a statement of financial position. This lays out what you own (in the form of assets) and what you owe (liabilities) as of a certain date. The difference between these two, assets minus liabilities, gives you something called owner’s equity, or shareholder’s equity. 
 
At this point, you may be questioning this logic, asking: What do you mean the equity section is only the assets minus the liabilities? Shareholder’s equity is generally comprised of two things.
  • The money you initially put into the business to get it started. If you are incorporated, you would have received shares of the company for the cash you contributed. If you aren’t incorporated this would be referred to as owner’s equity or partnership equity, if there is more than just you involved.
  • An accounting mechanism to capture the profit or loss measured by the income statement. This is referred to as retained earnings. A common misconception is that retained earnings is cash. But, it really isn’t. It links your income statement to your balance sheet.
A second report included in a set of financial statements is the income statement, or profit and loss statement. (It may also be called a statement of earnings.) This statement captures what happened in the business for a period of time – usually a year. It can also be just for a month or a quarter of a year. So, unlike the balance sheet, which is just a point in time, it runs from a beginning date to an end date. At the end of the end date, the net result is dumped into the balance sheet under the retained earnings account. The income statement then starts over with a new beginning and end date. The maximum period is a year (although 53 weeks is possible for some corporations.) I’ll come back to this statement later.
 
A third statement is called a statement of cash flows. Like the income statement, it too runs from a beginning date to an end date – and those dates are the same as the income statement. This statement explains what happened to your cash. Where did your business get cash from and what did it spend it on. It is broken into three categories:
  • Operating activities: this is your business’s ability to generate cash from what you are in business to do. So, can it survive without having to borrow from a lender, sell more shares (if incorporated), or sell assets to get more cash?
  • Investing activities: this captures what you put back into your operations in the form of capital assets or short-term investments. It is typically a negative number indicating you spent money on your assets. This is usually good because you want efficient machines making your products.
  • Financing activities: this section reports on repayments of debt, dividends paid to shareholders, and amounts borrowed.

So, how do you figure out if you are making money?

 
First, here’s a list of common accounting terms you will find on your income statement and what they mean:
 
Revenue: This represents the money customers pay for your goods or services. Another term for revenue is sales.
Cost of goods sold: This tells you what you paid for the product you are selling to customers at a higher price.
Gross profit: This number is your revenue minus your cost of goods sold.
Expenses: These are all the costs that helped you make the sale to the customer. For example, you need to pay rent so you have a place your customers can come to see your products; or you need to pay employees, pay for a telephone, and so on.
Income: This term represents the amount left over after you have recorded your revenue and subtracted all expenses. Other terms meaning the same thing are profits, net income, net profit or the bottom line.
 
Second, let’s look at what the numbers mean:
Revenue tends to get people excited and many small business owners think that if the revenue is going up all is well. But this isn’t true. If your costs, go up more than your revenue then you are actually losing money.
 
Gross profit is a very important number. It tells you if you are charging enough for your products so that you have money left over to cover expenses. It is actually a better number than either revenue or cost of goods sold on their own.
But what you really want to know about is the relationship between your revenue and your expenses. Many of the costs change when revenue changes. So, you need to see if any costs are changing faster than they should, and therefore costing you money.
 

How to determine the relationship between your numbers

So, now you should have a better idea of what the numbers represent. But did you know there is software that helps you to look deeper into the results? Finazz takes each of the numbers on your income statement and compares it to your total revenue. It then compares those percentages to last year, or some other benchmark.
 
This analysis is crucial because you need to compare two periods on the same common denominator. Otherwise, your comparison will not make sense.
 
For example, if you have 5 people on one team and 6 on another – you can’t really compare the two teams because they aren’t equal. The same goes for your income statement results.
 
Once Finazz compares the two periods, it gives you some alerts – green is good, yellow is a warning, and red is a potential problem. You can click on each of the coloured icons and get more information about how the cost behaves in relation to your total revenue. You also get some suggestions for how to fix the problem so it will hopefully be a green the next time you run the analysis.
 
This is an ongoing process. As you make changes to the way you run your business, run the analysis on Finazz. Your goal is to get as many green items as you can. If you get all greens, well, that’s just fantastic.
 
But it needs to stay that way. By assessing your results through Finazz.com each month you will be able to stay on top of things and relax a little. We’ve got your back!
 
A software program like Finazz helps you understand your finances in real time. It gives you tips you can put to use as well. This saves you time and money by not having to ask your accountant for insight on little, day-to-day questions about your statements.
 
Ready to learn more about Finazz?  Sign up for a free demo today!
 
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