Reading financial reports can feel overwhelming, but it’s a vital skill for any business owner. Knowing how to interpret a balance sheet and profit & loss statement helps you make informed decisions about your business’s future. You’ll gain insights into your financial health, allowing you to spot opportunities and avoid pitfalls. Unfortunately, many people shy away from learning this skill because they find the information confusing or daunting, and they tend to manage their business based on the amount of cash they have in their checking account!
Why Many People Struggle with Financial Reports
- Complex Terminology: Financial language can be hard to understand.
- Fear of Numbers: Many feel intimidated by math and numbers.
- Lack of Training: Not everyone has been taught how to read these reports.
- Overwhelmed by Data: Too much information can lead to confusion.
- Ignoring Importance: Some don’t realize how crucial these reports are for success.
Don’t worry! You can overcome these challenges with some easy steps.
Step 1: Understand the Balance Sheet
The balance sheet is like a snapshot of your business’s financial health at a specific point in time. A balance sheet can show you what you own and what you owe. It has three main sections: Assets, Liabilities, and Owner’s Equity.
1. Assets
These are the things that you own. Assets are everything your business owns that has value and are typically divided into current and non-current.
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- Current Assets: Cash, accounts receivable, inventory—items you expect to turn into cash within a year.
- Non-Current Assets: Equipment, property, and long-term investments—items that provide value over several years.
2. Liabilities
This section shows what your business owes to others. Like assets, liabilities are also divided into current and long-term.
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- Current Liabilities: Debts or obligations that are due within a year, such as accounts payable or short-term loans. This often includes credit card debt or payroll payables.
- Long-Term Liabilities: Obligations due in more than one year, like mortgages or long-term loans. This can include car loans or business loans borrowed for equipment, building, etc.
3. Owner’s Equity
What is left over. Think of this as the owner’s book value. It includes the money that you have contributed to the business, plus income that the business has earned over time, minus any distributions you have taken out of the business for personal expenses.
By comparing your total assets to total liabilities, you can determine your net worth. A positive net worth means your assets exceed your liabilities, indicating a financially stable business. This includes reviewing your cash to see if you can pay your short-term liabilities. You will also want to review your equity section to ensure your distributions have not exceeded the net income retained in the business. Regularly reviewing your balance sheet can help you identify trends and make necessary adjustments to improve your financial standing.
Step 2: Analyze the Profit & Loss Statement
The profit & loss (P&L) statement, also known as the income statement, provides a detailed account of your business’s revenues and expenses over a specific period, usually monthly, quarterly, or annually. This statement is crucial for understanding your profitability and is broken down into five sections: revenue, costs of good sold, gross profit, operating expenses, and net profit.
1. Revenue
This is the total income generated from sales before any expenses are deducted. It’s important to track revenue by different streams to see where your business excels.
2. Cost of Goods Sold (COGS)
This includes all the direct costs associated with producing the goods or services sold. Subtracting COGS from revenue gives you your gross profit.
3. Gross Profit
Gross profit is what your business actually earns for selling a product or completing a service. This is considered your real revenue.
4. Operating Expenses
These are the costs required to run your business that aren’t directly tied to production. This includes salaries, rent, utilities, marketing expenses, professional fees, etc.
5. Net Profit
This is what remains after all expenses, including taxes and interest, are subtracted from total revenue. A positive net profit indicates your business is making money, while a negative net profit suggests it’s losing money.
Don’t Forget to Analyze Trends
By analyzing trends in your P&L statement, you can spot patterns in revenue growth or expense increases. For instance, if your expenses are rising faster than your revenue, it may signal the need to cut costs or reevaluate pricing strategies. There are multiple ways to review your profit and loss.
You may want to compare quarter to quarter, which can show seasonality in your sales or expenses. A year over year comparison, however, can show you the growth (or lack thereof) of sales and/or expenses. Comparing to an established budget, will tell you if you are meeting your goals that you identified for the business at the beginning of the year.
Connecting the Dots
Once you have a solid understanding of both statements, use them together to gain insights into your business’s financial performance. By regularly reviewing your financial reports, you can make informed decisions, set realistic goals, and create strategies for sustainable growth. Understanding these reports will empower you to take control of your business’s financial health and success.
While reviewing and understanding your finances is important for any business owner, it doesn’t help to review financial statements that are incorrect. Categorizing transactions accurately can get a little tricky, even with the help of an accounting tool like quickbooks. The professionals at Aligned CPA can help you categorize your transactions to ensure accuracy and help you read your financials to help you make informed business decisions!
More than 80% of small businesses fail due to bad financial decisions. We want to help you be in the 20% that don’t!
Schedule your consultation today.
Cessie Cothran, MBA
Combining the CFO Advisory with tax strategy creates the best opportunity for financial success. We like to call it being perfectly Aligned. Our clients know they have us as a partner, helping them to feel secure about their financial future.