“If you didn’t want to make more money, you wouldn’t be an entrepreneur, right?”

Understanding Business Financial Statements

Let me take you through a series of questions that I want you to answer as honestly as possible.

Do you know how much money your business is making?

Do you know what your average net profit per month is?

Do you know what your average gross profit per month is?

Do you know what your current net asset position is?

Do you know how much your average total general expenses per month are?

Do you know what your breakeven point is?

Do you know what your total monthly average revenue is?

Do you know what your tax liability is likely to be at the end of this financial year?

What’s your customer lifetime value?

For every new customer you gain, how does this affect your expenditure?

And now for the most important question:

Would you like to make more money?

Of course yes you do. If you didn’t want to make more money, you wouldn’t be an entrepreneur, right? Your one true life goal and why most likely isn’t JUST to make money, but whether your goal is to assist other entrepreneurs, save the world, or just create a sustainable lifestyle for yourself that doesn’t involve a boss, it’s going to take money to do it.

The point is, if you don’t know where your numbers are at right now, how on earth are going to know how to improve them, and what numerical value you can realistically expect to improve them to? You won’t. That’s why its important to learn to keep and review your accounting records on a regular basis as well as how to read a basic set of financial statements.

I recommend using a package like Xero, Sage One, or Quickbooks to keep your accounting records, but you could even start in google sheets or excel. And you don’t need to know any fancy financial jargon or draw up immaculate financial statements using proper accounting standards to get started. You can literally get started with just a basic Income Statement and a basic Balance Sheet.

You can either prepare these yourself, or hire a bookkeeper that will use your bank statements, bills and invoices to generate these for you.

So let me take you through how to prepare/ make sense of each of the basic Income Statements and Balance Sheet.

The Income Statement (aka the Statement of Comprehensive Income)

The Statement of Comprehensive Income or for short, the Income Statement, is a statement that shows your revenue, cost of sales, gross profit, other income, net profit, other expenses, tax expense and net profit, generally in that order.

It should follow the following format more or less:

Company Name

Statement of Comprehensive Income for the year ended 28 February 20xx

Revenue shows your total gross income from core business related activities. If you’re running a virtual assistant agency, it will show for example the fees you charged to clients for services rendered.

Cost of sales shows all the expenses that are directly attributable to the revenue. These are the expenses that increase when you get a new customer.

Gross profit is the amount of money you make just from a service rendered to a client or a product sold.

Other income includes any income your business received that isn’t considered revenue.

Other expenses are any expenses that aren’t cost of sales, for example the cost of renting an office or software on a monthly basis, or website costs. These costs are mostly incurred whether you earn revenue or not and they shouldn’t really increase per service rendered or product sold.

Net profit before tax is then your total net profit before the year before taking into account what you owe the tax authorities.

The tax expense shows what piece of the pie you’re paying over to tax.

The net profit is how much your business actually made.

Different accountants may prepare this statement in a way that looks a little different, depending on what accounting standards, software and other legal requirements they’re taking into account when preparing them. It will also depend on whether they are producing management accounts or annual financial statements for you and whether these are interim or final, but generally all these statements follow this basic format. You just need to be able to spot the format in the statements to make sense of it.

Once you know where to find the information on the income statement, that’s when it gets fun, because that’s where you can start to play with the numbers and really read the story of what makes a business tick.

For example, try calculating the gross profit as a percentage of sales. This gross profit percentage indicates to you how much of the revenue you’re bringing in you have left after just taking into account the directly attributable costs. How wide is that margin? If this margin isn’t very wide, it means you’ve got a business that will rely on volume in order to be profitable. If you have a wide margin, it means that you’re likely in a business where you need to focus on selling high ticket items. The key to a volume based business is making sure you have enough contracts on the go and continue to get more on a continuous basis, where the secret to a high ticket business is making sure you’ve got your sales process down and very talented sales person executing it every day. You might invest more time, money and effort in keeping customers happy when you know your business relies on high ticket items, where you’ll likely focus a bit less on individual customer satisfaction and more trying to keep bulk customers as a general group happy when you’re running a volume based business.

You can do similar type calculations for each of the figures on the Income Statement. This blog post is not long enough to point all of them out to you, but tune in to our related Coffee Shop Conversations Show where I promise I’ll mention a few more, or join the premium membership and indicate that you’d like me to be your coach included in the membership and I’ll be helping you with your numbers and ratios on a weekly basis.

Or just draw up your Income Statement and start playing with it. See what ratios you can come up with that gives more insights into your type of business and if you then have questions tune in to our show to ask me live, or pop your questions in the comments on the YouTube show or on this blog post and I’ll get back to you.

You can also do trend analysis with your Income Statement. In this exercise you try to spot trends. For example, what expenses seem to be fairly stable each month? Which of these takes the biggest chunk out of your profit? Now, what could you possibly do to cut it down?

Or, is there a trend that shows that the more you invest in a certain software, the more one of your revenue streams grow? Or perhaps there’s a trend where two or three expenses always seem to increase at the same time. For example, employee cost and software expenses. Perhaps each new employee you bring on board has a host of non-employment expenses that gets influenced at the same time. We want to know what these are. Spot and know your trends, because you can only manage what you know.

The Income Statement is also a great place to spot the ‘funnel’ that turns revenue into net profits. When you play the profit maximisation game, your objective is to see what ‘process’ and pitfalls your revenue goes through in order to turn into profit - and then try to increase the amount of money you retain in profit from each bit of revenue you get to the max.

Also definitely look out for trends that indicate that when you invest in a certain expense, revenue grows by a certain amount. For example, I once had a client that got so good at marketing his business through Facebook adds, he would know exactly - if I invest $500 in Facebook adds, revenue will always grow between $1,000 and $2,000 (example numbers used). Because he knew of this relationship, our only job became making sure that we managed the rest of the ‘other expenses’ so finely that this increase in revenue would always lead to a corresponding increase in profit - and boom - we cracked the code.

There’s a lot more I could say on the Income Statement, but I believe for now this should be enough information to at least get your started on thinking about your numbers. Let’s for now, for the sake of the length of this post, move on to the Balance Sheet.

The Balance Sheet aka The Statement of Financial Position

The Statement of Financial Position, or the Balance Sheet, shows your net asset position. This means that it shows you the total assets, liabilities and equity of your business, and it breaks down your assets and liabilities between what is current and what is not.

It will usually follow a formula that looks similar to this:

It basically shows you your non-current and current assets. Then gives you the total of those assets added together. Then it starts all over, adding up equity and non-current and current liabilities to get the total equity and liabilities figure.

Your total assets will always match to your total equity and liabilities figure. That’s why it's called a balance sheet - because it always needs to balance.

Non-Current Assets are all the assets your business owns that aren’t readily available in the form of cash or something you can use in a similar fashion to cash. Think for example property, vehicles and equipment.

Current Assets are all the assets your business owns that are either cash, cash in the bank or something similar to cash that you can trade and buy with.

Total assets is simply the total of your non-current and current assets added together.

Equity is the residual interest of your assets less liabilities. It will typically consist of balances for retained earnings and something like members or share capital.

Member or share capital is the amount of money the owners have contributed to the business (usually to get it started). Retained earnings is the total amount of all the profit and losses the business has made since existence. A positive retained earnings figure indicates a business that is healthy and making money. A negative retained loss figure would indicate technical insolvency and/ or a business that is struggling to make money and keep alive.

Non-Current liabilities consist of all the money the business owes, but doesn’t have to repay in the next year.

Current liabilities consist of all the money the business owes and has to pay out in the next year.

Analyzing the figures in the balance sheet further helps us understand what makes a business tick. For example, a business that doesn’t have a lot of assets on the balance sheet, but that still displays a healthy retained earnings, is likely a human capital intensive or service based business. It will mean that the key to success with this type of business is having the right people on board who are doing the right things - even more so than with other business types.

A business that has a very high asset balance, might also have a higher liability or equity balance - because the funds for all that fancy equipment needs to come from somewhere and the balance sheet basically shows where the funds come from.

A business that has a lot of non-current assets, like specialised machinery and/ or valuable intangible assets might have a higher barrier to entry in the market, because someone that wants to get into the game would have to find a way to front all the necessary capital required for running the business up front, think for example of orchards. It takes a lot of money to establish an orchard and generally the product (fruit) only gets produced and becomes sellable after around 5 years or more.

Generally speaking, as a business owner, when you look at the balance sheet each year, or each quarter or each month your goal should be to increase the net asset value of the business. You want the assets to become more and the liabilities to become less.

Seen in reverse - the more assets you have on the balance sheet that haven’t been funded through liabilities, the greater the borrowing capacity of the business generally is, so the more you’ll be able to borrow, if/ when necessary.

Another ratio to pay attention to on the balance sheet is the ratio of current assets to current liabilities. These balances will include or completely represent your working capital balance. Working capital is the amount of money that needs to be invested in current assets in order for your business to be able to make money.

For example, its the stock you need to keep on hand, the credit you need to be able to extend and carry on customers and the trade payables you need to incur in order to keep doing business.

A lot of businesses grossly mismanage their working capital. You can ask yourself - does the customers owing balance really need to be that high? Are we actually going to be able to collect funds from those customers, or are they going to turn to bad debt that needs to be written off?

If you have a large stock item on the balance sheet you need to ask yourself, do we really need to keep that much stock to keep being profitable? Stock is basically money tied up in product - waiting to make money. Is there not maybe a risk that that stock will become obsolete or damaged or take a really long time to turn into money?

Of course it also could be true that stock levels are too low in which case customers might have to wait way too long to receive their orders, or debtors is too low and you could actually increase sales if you offered more competitive credit terms. That’s why we need to investigate - to figure this out - and understand what our business really looks like and needs and can produce - in number terms.

At the end of the day, whether your goal is to create the next spaceship that lands on mars, save the rainforests or just take care of and spend more time with your family - it takes numbers to accomplish, and the only way to figure out how to get those numbers is to know what they are right now, understand how they work, what the relationships between them are, and then work out the plan that’s going to make them add up to where you need them to be.

I’ve said a lot in this post! I hope it gets you thinking! But just before we wrap-up, let me give you three actionable steps you can take right now to get yourself started on your journey to understanding and managing your numbers better!

Step 1 - Draw up OR pull up a basic income statement for the past three months for your business

Use what I’ve shared with you in this post to draw up a very basic income statement that shows you your income statement figures over the past three months.

Step 2 - Draw up OR pull up a basic balance sheet as at the end of the last month

Use what I’ve shared with you in this post to draw up a very basic balance sheet that shows you your balance sheet figure as at the last available date.

Step 3 - Calculate three ratios and plan how to get them to where you want them to be

Use what I’ve shared with you in this post to calculate three ratios that you want to start tracking and understanding for your business.

To get started good ratios you might want to start tracking might be for example, your Net Asset Position (Net Worth), Total Revenue, and Total Net Profit before tax.

Once you have your current ratio figures, plan where you want these numbers to be in the next month, two months, six months and year. Write down what you are going to do to try and influence these numbers to get them to where you want them to be.

Now execute that plan and track your ratios every month.

As you do things the numbers will either move closer to where you need them to go or they won’t. If they don’t - come up with a new plan, until they start moving in the right direction.

And that is how we financially manage our way to where we want to, need to and deserve to be. 🙂

I look forward to seeing you on the show and answering all your questions! Feel free to drop them in the show comments or on this blog or join our premium membership if you want me included as your coach.

Until we chat again, have a beautiful day further and may all your numbers bring you closer to realizing your wildest entrepreneurial dreams!

If you found this article informative, please share it with others who might also benefit!

The first article in the Financial Literacy series is Financial Literacy and Cashflow Management, Click here to read the article.

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