My first thought when thinking about how to approach the subject of the most necessary reports for firm owners was that they're obvious. The top three would undoubtedly be the balance sheet, the profit and loss report, and the statement of cash flows. My next thought was to take it a different direction, and then my third thought was no--I absolutely and firmly believe that these are the top 3 reports that every business owner must know how to read.
Any picture that leaves out all three of these financial reports is incomplete. At the same time, almost every business owner knows how to read the profit and loss (P&L) report. Many, but not enough, really understand the balance sheet. Almost no firm owners seem to know about, much less understand, the statement of cash flows.
1. Profit and Loss
I know you already know how to read the profit and loss statement, so on this one all I am going to do is direct you to my previous post, “Analyze Then Maximize: Make the Most of Profitability Reports.” This post gets into specific ways to analyze your profit and loss statement to analyze and maximize profitability. That should cover your needed understanding of the profit and loss.
2. Balance Sheet
I’ve covered balance sheets before, so for a refresher you can take a look at this post: Your Balance Sheet and Your Time Billing and Accounting Software. In essence, your balance sheet is a snapshot. It shows you your assets, liabilities, and equity at a given moment. While that sounds simple, understanding it on a deeper level is the key to growing your firm.
That's why I want to really dig into the balance sheet. When we analyze the profit and loss, we are looking at things from the perspective of how much money we made. The balance sheet then answers the next logical question (among others): How much money did we keep? If we spent everything we’ve made, then our bank balances don’t increase. They'll likely decrease, because while we had no profits to retain in the bank, we're probably paying for things like credit cards and other liabilities.
The goal when we're analyzing the profit and loss is to make a profit. The goal when we're analyzing the balance sheet is to increase net worth. Net worth is equity.
How do we increase equity?
- Make a profit.
- Increase assets.
- Decrease liabilities.
If we pay for a fixed asset, it has zero impact on our net worth. We simply shifted money from our bank account to the fixed assets section of our balance sheet. The net effect on equity is $0.
Next, we're going to depreciate that fixed asset. That hurts our equity twice. It reduces our asset value and it also decreases our profit (this is a depreciation expense). Decreased profit reduces equity.
So the strategy is not to buy fixed assets. Rather, it is to buy a fixed asset that will produce a return. That fixed asset has to perform. This is why we look at things like ROA (return on assets), which helps us determine if that asset is performing. It has to increase our bottom line by more than the depreciation expense in order for it to pay off.
Earning a profit is a great start with a business, but in the bigger picture, we have to build equity in the firm. This means that the cash in the business has to be invested well. When we buy a fixed asset that produces a significant return, that--of course--means we have invested well. For example, if we purchase printing equipment that saves money compared to using an outside printer, that is a great investment. We increased assets while reducing an expense. That means our net income will increase.
Income / Assets = Return on Assets (ROA)
This is why the balance sheet is so important.
Now let’s look at the statement of cash flows.
3. Statement of Cash Flows
This is where it all comes together.
We start with net income (on an accrual basis) and we reconcile that with the cash in the bank at the end of the period. We do this by analyzing changes in account balances on the balance sheet.
In short, this lets us see where the cash flows are coming from.
We want to see the bulk of cash flows coming from operating activities. This means the company is producing enough cash flow on its own to sustain itself.
Then we look at investing activities. This should be negative. That means we’re investing our money. If cash flows from investing activities is positive, it means we sold or disposed of assets. That may or may not be a good thing depending on why we got rid of those investments. More importantly, we want to see cash outflows here, because it means we’re investing money into assets, which we then hope are producing a return.
Positive cash flows from operating activities with negative outflows from investing activities are great, especially if the net cash flow is positive overall.
The last part of the statement of cash flows is our financing activities. This is how much money the firm owners or partners are putting in or taking out of the business.
Oftentimes, an business owner will ask me how they made such a big profit but have so little in the bank. This is the first place I look to find the answer. Usually in these cases, the owner has taken the profits out in distributions.
The statement of cash flows has a way of removing the nonsense from the financial picture. It adjusts for non-cash items, like depreciation, and it shows us where we may be profitable, given that we're collecting our receivables. On the other side, we can be profitable, but if we have too much debt service, our cash flow can still be negative.
Any picture that leaves out any of these three reports is really incomplete. Looking at these three reports gives you a 360-degree view of your business. Everything else is just getting into the details of what is shown on the balance sheet, the profit and loss report, and the statement of cash flows.