Contents
Preface
Acknowledgments
Part I: Using External Reports to Gauge Your Company’s Health and Competitive Status
Chapter 1: The Key Financial Statements and Their Starring Role
Who Reads the Reports?
Are Your Business’s Financial Reports Private or Public?
Filling the GAAP
Why Accounting Method Matters to Your Bottom Line
Deciphering Double-Entry Accounting
Your Company’s Financial Road Map
Income Statement Accounts
Takeaways
Chapter 2: Balancing the Books: Your Assets and Liabilities
Rules Behind the Balance Sheet
Exposing Your Assets
Liabilities—Things Your Company Owes
Navigating the Equity Maze
Testing Liquidity
Takeaways
Chapter 3: Gauging Profitability
Understanding the Rules
Recognizing Revenue: Not As Simple As It Seems
Tracking Cost of Goods or Services Sold
Why Gross Profit is Important
Acknowledging Expenses
Testing Profitability
Takeaways
Chapter 4: Cash Is King
Key Sections of A Statement of Cash Flows
Formatting the Statement
Reviewing Investing and Financing Activities
Looking Behind the Numbers For Operating Activities
Bottom Line: Cash Flow From Operating Activities
Impact of Investing Activities on Cash
Eyeing the Impact of Financing Activities
Special Activities That Impact Cash
The Bottom Line
Testing Your Cash Flow Position
Takeaways
Part II: Using Internal Reporting to Manage Your Profits and Your Costs
Chapter 5: Why Budgeting Is Important
Who Should Be Involved in the Budgeting Process?
Starting With A Sales Forecast
Determining Your Cost of Goods or Services Sold
Tackling Expenses
Reviewing Cash Needs
Tracking Your Success Through the Year
Takeaways
Chapter 6: Managing Inventory
Understanding Inventory Valuation
Calculating Inventory and Cost of Goods Sold
Comparing Inventory Valuation Methods
Testing Your Inventory Turnover
Borrowing Against Inventory
Takeaways
Chapter 7: Monitoring Customer Collections
What is Accounts Receivable?
Calculating the Accounts Receivable Turnover
Digging Into Accounts Receivable
Developing Accounts Receivable Policies
Borrowing On Receivables
Takeaways
Chapter 8: Discounts and Special Pricing
Discount or Special Price
Tracking the Impact of Discounts On Your Bottom Line
Special Pricing: Pro or Con?
Takeaways
Chapter 9: Getting a Handle on Manufacturing Costs
Determining Cost of Goods Sold in Manufacturing
Inventory Value in A Manufacturing Environment
Exploring Fixed Versus Variable Costs
Special Pricing Deals and Manufacturing
Calculating the Impact of Lower Prices
Takeaways
Chapter 10: Reducing Bill Payouts
Your Bill-Paying Turnover
Evaluating Bill Payment Discount Offers
Delaying Bill Payment
Takeaways
Conclusion: Using Financial Statements for Decision Making
About the Author
Index
Copyright © 2012 by Lita Epstein. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Epstein, Lita.
The business owner’s guide to reading and understanding financial statements : how to budget, forecast, and monitor cash flow for better decision making / Lita Epstein.
p. cm.
Includes index.
ISBN 978-1-118-14351-3 (paper); ISBN 978-1-118-22558-5 (ebk); ISBN 978-1-118-23109-8 (ebk); ISBN 978-1-118-23112-8 (ebk)
1. Cash flow. 2. Decision making. 3. Financial statements. 4. Corporations—Finance. I. Title.
HF5681.C28E67 2012
658.15'12—dc23
2011038806
Preface
Most small-business owners become very familiar with the income statement, which you may also know as the profit and loss statement, statement of operations, statement of earnings, or statement of operating results. Whatever you call it, this statement gives you a summary of the financial results of your business’s operations over a certain period of time.
The bottom line of the income statement can be a net profit or a net loss. As long as the bottom line shows a profit and the overall trend is upward, many business owners are happy to receive this detail from their accountant and then go back to running their business.
Are business owners doing enough? With the U.S. Small Business Administration concluding that the five-year survival rate for new businesses is just over 50 percent, clearly this information combined with a business owner’s experience is not enough for about half of all new business owners.
Why do businesses fail? Among the top 10 answers are five that can be directly tied to the need for better understanding of financial statements:
1. Insufficient cash
2. Poor inventory management
3. Overinvestment in fixed assets
4. Poor credit arrangements
5. Unexpected growth
The income statement alone cannot help you deal with any of these five problems. You need to have a better working knowledge of what goes into the income statement as well as two other key financial statements—the balance sheet and the statement of cash flows—to really get a handle on whether your business will succeed or fail.
LOOK BEHIND THE NUMBERS
Few business owners take a closer look behind the numbers that are collected to produce an income statement. Nor do they pay much attention to the numbers behind the other two key external reports: the balance sheet and the statement of cash flows. Even fewer develop customized internal financial statements to keep on top of their business’s financial health.
These internal statements don’t require extra data collection—the data are already being collected to prepare the three main external financial reports. By designing internal financial reports, you can use data already being collected to get a more complete picture of what’s happening in your business.
In this book, I help you get a better understanding of the data collected to develop the key external financial statements. I give you some tools for developing internal financial statements so that you’ll have a better handle on your business’s financial health by taking a closer look at such things as your customer’s payment habits, your inventory turnover, and your cost control.
First, let’s take a quick look at the balance sheet and statement of cash flows. The balance sheet gives you a snapshot of how much you own, how much you owe, and how much equity you have in your business as of a particular date. I delve more deeply into how you can use the statement to measure your financial results in Chapter 2, “Balancing the Books: Your Assets and Liabilities.”
The statement of cash flows does just that; it reviews what cash has come into the business and what cash has gone out. The bottom line of this statement is your net cash position, which can be very different from your net profit. I help you understand why that’s the case as we delve further into this topic in Chapter 4, “Cash Is King.”
With the knowledge you’ll gain from having a better understanding of how to use the financial statements, you can analyze how well your business is doing and make course corrections quickly to keep your business profitable. In this book, I take you through a crash course on what data go into each of the three key financial statements and how you can use these statements to gauge the profitability of your company, get a handle on your company’s liquidity, and test your company’s cash position.
CUSTOMIZE YOUR INTERNAL REPORTING
Once you’ve completed this crash course on how to make the best use of these financial statements—which include the external reports that you must provide to your bankers, vendors, government entities, and others with whom you do business that require financial reporting—I take a closer look at internal reports you can develop to keep even better tabs on your company’s financial well-being.
Internal reports are the kinds of reports that include detail you don’t want outsiders to see. For example, if you sell your product by providing credit to your customers, you need to monitor whether your customers are paying you on time. If they aren’t, your cash flow will be negatively impacted and your business’s ability to continue to operate could be at risk. Even though your income statement is showing a profit because of the revenue earned, your company could be heading to a cash flow disaster.
Of course, you don’t want outsiders to know the details of even who your customers are, so instead you develop an internal report called an Accounts Receivable Aging Schedule. This report details who’s paying on time and who’s late—and how late they are. You need to decide when you want to cut off a customer who’s past due. In Chapter 7, “Monitoring Customer Collections,” I give you the tools you need to help you determine this and other questions you may have about collecting the money due on time using internal reporting and analysis.
Another key area in which internal reports can help you improve your bottom line is gauging your success in moving your inventory, which I take a closer look at in Chapter 6, “Managing Inventory.” In addition to moving that inventory—especially if you are operating a manufacturing business—you need to monitor its costs, which I discuss in Chapter 9, “Getting a Handle on Costs.” Using internal reports, you can track cost trends and adjust pricing before it has a negative impact on your bottom line.
You’ve probably used discounts and special pricing to entice customers (or buyers for major stores) to buy your products, but do you know how much impact those discounts have on your bottom line? In Chapter 8, “Discounts and Special Pricing,” I show you how to use internal reporting to track those impacts so you can adjust your month-end and year-end projections to account for that impact. Making use of discounts and special pricing without monitoring their impact on your overall profitability could lead to a business disaster of insufficient cash and disappointing profit results.
In Chapter 10, “Reducing Payouts,” I take a closer look at proper bill pay management and how that can help you reduce your cash outlay. I discuss some simple steps you can take to be sure your bookkeeping staff is taking advantage of all vendor discounts by paying within a certain period of time, which can improve your bottom line.
Internal reports can help you make these key decisions:
- Determining which of your company’s products produce a profit and which produce a loss.
- Determining what parts of the company should receive additional resources to encourage growth.
- Identifying unsuccessful parts of your business and making needed changes to turn the troubled project around or kill the project.
- Determining appropriate staffing and inventory levels that you need to meet customer demand.
There is no limit to the variety of internal reports you can create to manage your company effectively. There are no accounting rules one must follow when designing internal statements. In this book I give you some tools to get you started, but working with your accountants and your managers you can design reports that help you make decisions about key issues that impact your business’s success using data already collected for the external reports.
BUDGETING FOR RESULTS
All these internal reports will be based on proper budgeting, which I talk about in Chapter 5, “Why Budgeting Is Important.” You may or may not operate using a well-thought-out budget. Many business owners prepare a budget as part of their business plan and then ignore it most of the year. At the end of the year, they take a look to see how well they guessed at the results.
That’s not necessarily a smart way of doing things. Budgeting on a month-by-month or even week-by-week basis can help you keep an eye on how well your business is doing. By developing a realistic budget up front and then monitoring your success at staying on budget, you can quickly recognize red flags that could lead to disaster year-end if changes aren’t made. I show you how to use internal reports to help you quickly find those red flags so you can make a change midstream.
For example, you could have developed your anticipated revenues based on a certain level of sales, but because of an economic downturn you have no chance of reaching that level. If you quickly adjust the rest of your budget to reflect reality, you can probably avoid a major cash flow problem. It could mean reducing staff to reflect the slower pace of business, as well as reducing product orders. If you own a manufacturing company, it could mean you should reduce production.
Just as dangerous, the opposite could happen after you developed your budget for the year. The economy could recover more quickly than you anticipated, and you won’t have enough products to meet sales demand unless you adjust your budget projections and order or produce more products. Maybe you’ll even need to hire more staff than you had planned to meet demand. If you don’t have the product available or the staff you need, you could lose customers to your competitors.
Developing realistic budgets and then using them to monitor your business can help you stay alive in both good times and bad. They enable you to make corrections midyear so that you don’t face a period of insufficient cash, poor inventory management, not enough credit (or paying too much for credit), and unexpected growth.
Yes, unexpected growth can be just as devastating to a new business as a reduction in business. A new business that can’t meet its demands from customers is more likely to lose them because the new business owner may not be able to depend on long-term customer loyalty. Whereas a well-established business may be able to hold on to its loyal customers if a product the customer wants is not immediately available, a new business won’t likely have had time to build that customer loyalty. Instead, the new business owner will likely lose the sale to a competitor.
So let’s get started on this journey to delve into financial statements and how they can improve your business’s chance of success. I start in Chapter 1 by looking at the role the three key financial statements play in tracking your business’s results.
