Finding the Meaning in Your Financials
The last few weeks we spent some time breaking down the three main financial documents every small business owner should be familiar with: The Profit and Loss Statement, the Balance Sheet, and the Cash Flow Statement. But for many business owners, these documents can still be hard to parse, even if you know what you're looking at.
So, let's breakdown some of the key financial metrics these documents can help you better understand about your business.
The most obvious metric that can be better understood through your financials is profitability. In particular, the Profit and Loss Statement (P&L) is designed to show exactly that. If you understand nothing else from a P&L, you should know that the number at the very bottom should be positive. If it's negative, then you probably have a problem.
But, what other types of profitability metrics can be gleaned from studying your financials? For starters, Net Profit (AKA, "bottom line") is not the only type of profit you should be looking at. Comparing Gross Profit over time can tell you whether your raw costs are going up, or if labor costs are too high, or even whether you should increase your prices. Operating Profit can tell you whether your overhead is increasing, or whether you might want to take a closer look at your tax structure. While it's good to have a strong bottom line, sometimes the truth of your finances can be buried deeper in the P&L.
Financial gurus over time have developed several important ratios that can be determined based on the numbers on the Balance Sheet. Each ratio gives you a different glimpse into your business, and taken together they can be a valuable tool.
Working Capital = Current Assets – Current Liabilities
Essentially, Working Capital helps you understand how much you have left to play around with if all your liabilities were called at the same time. If you have more current liabilities than current assets, you're in danger of hitting a cash crunch in the near future. This is something that wouldn't be obvious from a P&L, since a company could be profitable and still not have enough cash to cover a crunch.
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Sure the Quick Ratio may look the same as Working Capital on the surface, but there is a fundamental difference. Working Capital includes inventory in the asset category, which is essentially assuming your inventory could be easily sold and converted into cash in a crunch. But what if you sell something that can't easily be sold quickly? Say, like airplanes, for instance. That's where the Quick Ratio helps give you a clearer picture of your true short term cash position.
Debt to Total Assets = Total Debt / Total Assets
Debt to Total Assets Ratio gives you a snapshot of what is considered the company's financial leverage. This means what percentage of the company's assets were purchased with debt. For example, a company may have a lot of cash on hand, and if the Debt to Total Assets ratio is high, you could assume this cash came from loans as opposed to running a profitable operation.
The Flow of Cash
Another key way these financial documents can give you insight into your business is by highlighting the three primary ways cash can move in and out of your business: operations, investments, and financing.
The operating section of the Cash Flow Statement tells you how much cash you’ve received and used in the routine operations of your business. Essentially, it's the P&L condensed down to a few lines. The investing section deals with cash flows for big projects (such as equipment and property purchases), as well as purchases and sales related to stocks or other investments. The financing section gives you an idea of how your business is financed.
By breaking down cash flow into these three basic categories, the Cash Flow Statement makes it easy for small business owners to get a handle on why the cash balances went up or down. For instance a profitable company could hit a cash snag if they spend all their money on buying an expensive piece of equipment. Understanding your cash flows can help you budget for the future and identify potential financial problems before they even start.
If you'd like to learn more about what your financial statements mean, reach out to us for a free business evaluation.