For many entrepreneurs, financial statements may as well be a foreign language. Business owners often haven’t been shown how to make sense of them, and as a result, these statements are misunderstood and drastically underutilized.
But in the world of business, information is power. Even a cursory understanding of key financial statements and concepts can transform how you see your business and drive toward growth.
Let’s start with “the big 3” financial statements businesses use to inform future decisions and protect themselves from undue risk:
- The profit-and-loss statement
- The cash flow statement
- The balance sheet
The Profit-and-Loss Statement
What is it?
A profit-and-loss statement – often called a P&L statement – summarizes the revenues, costs, and expenses a business incurs during a given period. Essentially, it measures a company's profitability, highlighting how much it makes and spends. The P&L statement may also be referred to as an earnings statement, an income statement, or a statement of financial results.
Public companies are required to submit these statements on a quarterly and annual basis, and it is considered best practice for private companies – even small ones – as well.
What does it include?
- Revenue – How much a company brings in from the sale of goods or services
- Expenses – The amount a company spends, which typically includes line items such as wages, rent, utilities, etc.
- Gains – Income earned from sources outside a company's core business operations (i.e. the sale of assets above their value at the time of acquisition)
- Losses – Any negative financial outcomes (i.e. selling assets below their value at the time of acquisition)
- Net income – Better known as “the bottom line”, this highlights what a company earned after accounting for all profits, gains, and losses.
Why is it important?
The P&L statement gives you insight into your company's profitability—because revenue is only part of the story.
If your organization is spending more than it is bringing in, it is running at a loss, and this information is necessary to make key adjustments in your business moving forward.
If you undertake a strategy to reduce costs, the P&L statement can provide critical insight into how well that strategy works to increase profitability. The statement can also help you calculate profit margins, which measure how adept your business is at turning revenue into profits.
And the greater your profitability as a business, the more you can reinvest in strategic growth areas and the more valuable it becomes when considering a potential exit.
The Cash Flow Statement
What is it?
While the P&L statement focuses on profitability, the cash flow statement focuses on the movement of cash in and out of a business.
Cash is the financial lifeblood of a business and makes it possible for companies to afford current and future expenses. The cash flow statement allows businesses to track cash over time, making it possible to identify trends and make changes as necessary.
What does it include?
- Operating activities – Cash flow from core business operations. Cash comes in via revenue, interest, and dividends, and goes out via payments to suppliers, employee wages, and other hard costs.
- Investing activities: Cash flow from long-term investments. Cash comes in from selling assets or collecting payments on loans and goes out through capital expenditures and business acquisitions.
- Financing activities—Cash flow related to raising and repaying capital. Cash comes in from issuing stock or borrowing money and goes out through loan repayments, for instance.
Why is it important?
Cash flow affects whether a business can meet its financial obligations, navigate unexpected challenges, seize growth opportunities, and maintain overall financial stability. The cash flow statement allows you to track cash flow over a given period and highlight current or potential areas of concern so you always understand your business's liquidity.
The Balance Sheet
What is it?
A balance sheet is a summary of assets (what a company owns), liabilities (what a company owes), and shareholder equity at a given point in time. It highlights a company’s working capital—its ability to cover debts that are due within the next 12 months or to invest in other aspects of the business.
What does it include?
- Assets – What a company owns
- Liabilities – What a company owes
- Shareholder equity – A company's net worth, or its total assets minus its total liabilities
What is it important?
The balance sheet determines whether a company can meet all near-term obligations while providing funding for investments in the business or possibly returning funds to shareholders. (If you are the sole owner of the business, those returns benefit you in a big way.) If a business does not have enough working capital, the balance sheet will show it and allow your organization to take steps to mitigate risks and plan for a successful future.
A Snapshot in Time
The “big 3” financial statements all have one thing in common: They show where a business is at a given point in time. Financial ratios, or metrics, such as the gross margin, net margin, debt-to-equity ratio, and many more can be extracted from the statement. Then the question becomes, what do you do with that information?
This is one of many areas in which a fractional chief financial officer can provide tremendous value. A CFO can look at these ratios and determine what’s going well and what is not. This is not done in a box. A good CFO will ask questions like, “What have these ratios been historically?” “How do these numbers compare to the competition?” and “What past or current factors contribute to these numbers?”
A CFO can also determine which ratios are the company's key performance indicators (KPIs). KPIs vary from company to company; some don’t appear on the financial statements and instead require further analysis of related information. These include things like the return on investment for specific marketing and sales activities, conversion rates on the company website, and customer retention rates.
With so many potential key performance indicators available to business owners, it takes detailed analysis to define the metrics that determine whether a business is on the right track to achieve its short and long-term goals. A CFO can be a trusted resource and valued partner in complex financial and business analysis.
