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One of the biggest mysteries of my business is that most of my clients do not want to review their financial statements monthly or even quarterly. Is it because they trust us so much? No. Is it because we are so good at keeping their books? No. Is it because I have assured them I will “watch out” for their business? Sadly no.
It is because they do not understand the elements of their statements and this is backed by research. A 2019 SBA report showed that over half of small businesses were not reviewing their financial statements. And of that 50%, 86% were experiencing financial difficulties.
Businesses weren’t reviewing their statements … because they didn’t understand financial jargon. This week we are going to have a quick lesson in financial terms. I am putting the full podcast in the show notes this week, so use it as a reference while you’re working with your accountant or while going over your books each week, month or quarter.
First the easy stuff:Income Statement
Your income statement is also called a profit and loss statement or earnings statement. An income statement shows all the money your business makes (i.e. profit).. Income statements are generated for a fixed period of time - generally monthly, quarterly or annually depending on the company and their needs. It is very helpful if it includes the information for the same time period for the comparative prior periods.
Example: First quarter of 2020 as compared to the first Quarter of 2019. Then you can use the data to compare results against same time frame.
The Income Statement has several major sections that should be in the following order:Gross Sales or Revenue
Gross sales includes the total of all sales activity during a reported period. Items like sales discounts, sales returns, and sales allowances are recorded on separate lines form Gross Sales.Net Sales or Net Revenue
Revenue is the total amount of money a company brings in from its business activities after discounts, returned goods, and other sales allowances have been deducted. Businesses that sell goods, such as retailers, are more likely to refer to revenue as net sales. It is also called top-line because it usually appears at the top of an income statement.Cost of Goods Sold or Cost of Revenue
Cost of goods sold refers to the full cost for the production of the goods a business has sold.
For example, if you sell shoe lace, the money the customer gives you to buy the shoe laces is revenue and the money you pay to the supplier for the shoe laces is cost of goods. Another example, if you have a mental health therapy business, the amount the patient pays you for a session is revenue. The amount you pay the therapist for an hours work to conduct that session is cost of services.
An accurate calculation of the cost of goods or services is critical to efficiently run your business.
Gross profit is the cost of goods sold or cost of revenue subtracted from net sales. This is the first and most important judge of the health of your business as it is the first determinant of how profitable a company is. It indicates the profitability of the products and services the company offers before considering operational expenses or overhead.Gross Profit Margin
Gross profit margin refers to the ratio of the revenue that you keep as gross profit. It is also called gross margin or gross profit percentage.
The formula to calculate this is (Gross Profit/Net Sales) x 100.
A detergent business whose gross profit is $20,000 with net sales of $50,000 has a gross profit margin of 40%. This means the detergent sold returned 40% on the capital that’s directly associated with the detergent production.
Now for the OverheadOperating Expenses
Operating expenses are the costs tied to a business’s core operations outside of production costs, which are generally classified as cost of good sold. Operating expenses include selling, general and administrative expenses that are not directly related to the production of the company’s products or services.Selling, General, and Administrative Expenses (SG&A)
Selling, general, and administrative expenses are expenses you incur while selling your products and services. They also include the cost of running your business on a daily basis. Below is a breakdown:
Selling expenses include the cost to sell the goods you’ve already produced or purchased. This excludes cost of production or purchase. It includes: expenses related to sales material, traveling, advertising, delivery, warehousing, telephone bills, salaries of sales employees, and sales commission.
General and Administrative expenses are usually more fixed than selling expenses. They include expenses related to rent, mortgage, insurance, utilities, and salaries of non-production and non-sales employees.
Operating income is the revenue or net sales that’s left after you deduct operating costs. It is also called operating profit or earnings before interest and taxes(EBIT). Its calculation excludes non-operating expenses like interests, taxes, lawsuit settlement expenses, etc.Operating Margin
Operating margin is the ratio of revenue or net sales a business keeps as operating income. It is calculated by dividing operating income by revenue or net sales. The result is then presented as a percentage by multiplying by 100.
For example, a business’s operating income was $10,000 on a $50,000 revenue or net sales. Its operating margin is then $10,000/$50,000 = 0.2 x 100 = 20%.Operating margin helps determine how efficient a company’s day-to-day operations are. In the example above, the business’s day-to-day operation made $0.20 for each dollar of revenue. Non-Operating Expenses and Loss
Non-operating expenses are costs incurred due to activities unrelated to a business’s core operation. These activities don’t have tangible effects on operating results. This includes, but is not limited to, interest and insurance.
A non-operating loss is loss incurred from activities that don’t relate to business operations. A good example would be a loss incurred as a result of a lawsuit settlement or a flood.Non-Operating Revenue and Income
Non-operating revenue and income is the total profit created by a business from activities that aren’t tied to its core operations. Examples would include proceeds from selling business equipment or realizing a gain on a special transaction.Net Income
Net income is gross profit minus all other expenses incurred during the reported period and also reflects any additional non-recurring income and expenses.
It is the overall determinant of how profitable a business is. Here’s an example. If your gross profit is $20,000, and you spent $10,000 on operating and non-operating items, your net income would be $10,000.
Those are the elements of the Income Statement or Profit and Loss.
Net Revenue less Cost of Goods or Services equals Gross Margin. This is what you have left to pay for overhead and yourself.
Operating costs are Selling, Marketing and Administrative. When you subtract this from Gross Margin you have Operating Profit. This is what tells the health of your business.
Then there are the one time, odd things like floods, sale of equipment, interest and tax expense that are called Non-operating income and expenses.
The bottom line calculation is called Net Income, which is what is left over for the owners.
Now it gets a little more complicated. Let's talk about the Balance Sheet.Balance Sheet
Your balance sheet gives an overview of the financial situation of your company. Unlike an income statement, a balance sheet offers a snapshot of a business’s finances at one specific moment in time.
A balance sheet consists of three segments:
“Assets” - which are everything you OWN
“Liabilities” - which are everything you OWE
“Owner’s Equity” - what is left for you.
These three segments must balance out in a simple equation. Assets = Liabilities + Owner’s Equity. Hence, the name balance sheet.Assets
An asset is any item your business owns that is of fiscal value and is expected to benefit the business in the future.Cash and Cash Equivalents
Cash and cash equivalents are assets and items that a business can easily convert into cash. Cash equivalents could include checks, certificates of deposit, and treasury bills. If your business doesn’t have cash equivalents, it would only report its cash-on-hand and in the bank.Accounts Receivable
Accounts receivable is the amount of money a company has invoiced that has not yet been paid by the customer. It is from having sold goods or rendered services to its customers. This is what other businesses or customers owe your business.Prepaid Expenses
Prepaid expenses usually arise when businesses pay in advance for goods and services needed in the near term.. Prepaid expenses usually appear on a balance sheet in the current assets subsection. This is because they’re usually due within 12 months. Prepaid expenses
Insurance is one example of a prepaid expense. For example, assume your business pays up front for an an insurance policy of $2,400 with a 12-month term. You will initially have a $2,400 prepaid expense asset on your balance sheet. As each month passes over the 12 month period, you’ll reduce this asset by $200 and record an expense until the expense has been equally recognized over the course of the term.
Other typical prepaid expenses include rent, supplies, legal and other products or services paid for in advance.Inventory
Inventory is the product you have on had to sell, but has not yet been sold. For example, all the books on the shelves in Barnes & Noble are inventory. Things they have purchased to sell, but have not yet been sold.
Fixed assets are a long-term tangible piece of property or equipment that a firm owns and uses in its operations to generate income. Fixed assets are not expected to be consumed or converted into cash within a year. Fixed assets most commonly appear on the balance sheet as property, plant, and equipment(PP&E). They are also referred to as capital assets. An example would be manufacturing equipment, delivery trucks, computers, etc.
The next section of the Balance Sheet are the LiabilitiesLiabilities
A liability refers to any financial amount a business owes. This includes trade and accounts payable, accrued expenses, loans, mortgages, and even advance payments received from customers for goods and services not yet delivered or rendered. Liabilities are reported on balance sheets as short-term (current) and long-term liabilities. Current liabilities are typically obligations that are due within a year.Accounts Payable
Accounts payable is also called trade payable. It refers to the total invoices for goods and services a business has received, but has yet to pay. They’re usually due for payment within 15 to 45 days. In short, this is money your business owes to other businesses.Accrued Expenses
Accrued expenses are expenses that a business has incurred but has yet to pay. This is because either the invoices have not yet been received or the payments aren’t yet due. Accrued expenses are generally created by an accounting entry to reflect these liabilities.
Examples of accrued expenses include interest on loans and taxes incurred. Salaries your employees earn up to the period of reporting, but aren’t due for payment until after the report is prepared, are also accrued expenses.Unearned Revenue
Unearned revenue refers to advance payments a business receives from its customers. It is also called deferred or prepaid revenue. It’s considered a liability because you received the payment but haven’t delivered the product or service yet.
Unearned revenue is treated similar to prepaid expenses. Whereas the prepaid asset is reduced and the expense is incurred monthly over the period of a contract the opposite is true for unearned revenue. In this case, income is incurred evenly over the period of a contract and the liability is reduced accordingly.Notes Payable and Notes Receivable
Notes payable are are amounts due to other parties outside of your usual trade and accounts payables. . These could be funds borrowed from a bank or an amount owed to a supplier for raw materials delivered. Notes payable are a debt instrument. They are recorded as a current liability on a balance sheet if due within 12 months.
Notes receivable is the opposite of notes payable and represents amounts owed to you that are outside typical customer receivable transactions Examples may include loans made to employees or shareholders. Notes receivable appear as a current asset on a balance sheet if expected within 12 months.Owner’s Equity
Owner’s equity is the totality of the owner’s investment into the business. This is the portion of assets that belongs to the business owner. It is derived by deducting total liabilities from total assets. Owner’s Equity is not the fair market value of a business.Statement of Cash Flow
Cash flow refers to the flow of cash moving into and out of a business over a fixed period of time.. When a business receives more cash than it sends out, it is cash flow positive. A business is cash flow negative when it spends more than it receives.
Everything is recorded on your Income Statement or your Balance Sheet. Every item has two sides, thus Double Entry Bookkeeping. So, if you pay the electric bill, the payment is recorded as an expense in the Income Statement under the category of Utilities and the other side is a reduction to cash or an increase in accounts payable.
Managing your finances is one of the most important parts of running a business. Unfortunately, small business owners who have little financial background shy away from these responsibilities. By learning these key financial terms, you’ll be more able to understand your financial statements, communicate with finance professionals, and monitor your business’s cash flow.
If you have any questions email me at email@example.com. Until next week Live Rich!
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