Financial statements keep track of the financial side of the business.
Through education and experience, I have learned the language of numbers, thus the balance sheet and income statement always tell me a story. It may be a short story or it could be lost within pages and pages of number, but there is always a story. The stories are usually not as exciting or entertaining as a comedy, a horror movie or a romance novel, but they can tell you a lot if you are looking.
For most small businesses, the financial statements come up short. They are typically incomplete and inconsistent. Let’s break it down into chapters.
Chapter 1. Income. Record sales when the services or products are provided, not sooner or later. Break it down by type of customer or by products and services you are selling. Type of customers could be residential, commercial, wholesale, business, etc. In my business the type of sale could be bookkeeping, payroll, tax, consulting, etc. By comparing one period to another a reader can see the story changing – watch the type of customer growing or shrinking or the type of products or services growing or shrinking. You are looking for trends – where your customers are taking you.
Chapter 2. Direct costs. Group the costs the business must incur to deliver the products or services it is selling. These costs typically vary as sales vary. Record them at the time of sale, if feasible. It is critical that the business cover direct costs on every customer and for every service.
Chapter 3. Gross margin. This will tell you if the business will live or die. Calculate and monitor both the dollar amount and the percentage of sales. For the company to stay alive this needs to be greater than overhead. The goal is to keep this growing both in dollar and in percentage. Changes in the customer mix and product mix will change how much hits the bottom line, the ending of the story.
Chapter 4. Overhead. Group the remaining expenses as decisions are made. Here’s a basic list.
- Salaries and benefits. By comparing total salaries to total sales the company can make the decision to hire additional staff, provide more in benefits, or work on making staff more productive.
- Marketing. By comparing the relationship between marketing and sales, you can determine how productive your efforts are.
- Occupancy expenses. By grouping rent, utilities, Internet service, phone, etc. management can watch to make sure that these expenses are constant from month to month.
- General and administrative. These are expenses necessary just to have a business. It includes office expenses, insurance, professional fees, bank charges, and everything else that doesn’t fit within another category. Typically this amount is consistent from month to month.
- Depreciation & amortization. I separate these out because they are non cash expenses. They can fluctuate based on tax elections and do not reflect on the overall management of the business.
Chapter 5. Calculate Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). This is the technical term to determine how productive operations are. Taking out the financial decisions on interest, taxes, depreciation and amortization – operations is left. To get an accurate portrayal of the business financial picture, be sure to include reasonable wages for you, the business owner.
We broke down the Income statement; however, this just illustrates how a business can generate a profit. The Balance Sheet will give you a hint of what the company has to work with to generate that profit and the Statement of Cash Flows; will tell you how the business used the cash that came through their door.
Once all the numbers work out – you too can live happily ever after.