THE IMPORTANCE OF GOOD BOOKKEEPING IS CLEAR
Most business owners didn’t launch their companies because they love numbers. They may love to write software code, practice law or manufacture precision tools — but financial statements probably aren’t the first thing many think about when they wake up each day. Still, it’s important to have a solid handle on your company’s income and expenses. Your accounting system gives you a way to spot and solve problems sooner rather than later.
Fortunately, it’s not difficult to master the basics of your financial statements. Here’s a quick primer:
These statements organize information in clear and consistent formats, helping you to pinpoint your company’s strengths and weaknesses and troubleshoot problems. The most important parts are the balance sheet, income statement and cash flow statement.
Taken together and compared year-over-year, these documents help you answer several key questions, including:
- How strong is my ability to cover expenses? How do I know my business will remain solvent?
- How fast am I turning inventory into sales?
- Are my customers paying according to the terms we agreed upon?
- How efficient are my operations? Am I getting the best return possible? How can I reduce costs?
- For every dollar I generate in sales, how much is left to cover my operating, sales and administrative costs? How much profit have I made?
- What can I do to increase my profits?
- Are my profit margins increasing or decreasing year-over-year?
- How does my financial performance compare to peers in my industry? (Talk with your banker, who should be able to help review your company’s financial performance with comparative industry data.)
Your balance sheet shows your financial condition at a moment in time. It covers:
- Assets. These are the things your company owns. When the values of assets are added up, the result represents the total amount of funds invested in your enterprise.
- Liabilities. These are what your business owes, i.e., your business debts. They represent the investment of creditors in your company.
- Equity. This represents your personal stake in the business. It also provides an indication of your company’s strength and ability to weather adversity.
Balance sheets break down assets and liabilities. Current assets are those that will be converted to cash within a 12-month period and are listed separately from long-term assets. Current liabilities, which are debts coming due within a year, are listed separately from long-term debt.
Income statements start by showing total revenues over a period of time — three months, six months, a year. Then costs are subtracted from these numbers, in this order:
- Cost of producing and selling goods
- Operating and general administrative expenses
What’s left is net income, the amount of your company’s profit (or loss) for the period. That’s the proverbial bottom line.
Cash flow statement
A cash flow statement shows cash entering and leaving your company. Unlike an income statement, it shows net income adjusted for revenues or expenses reported, but not yet collected or paid, also called non-cash items. This is important — as owner, you want to see cash income growing over time.
Different ratios are used to express relationships between line items on financial statements. You should understand the most important of these financial ratios, since they can provide an early warning system for future problems:
- Current ratio. This measures liquidity by comparing current assets to current liabilities as shown on the balance sheet. The higher the current ratio, the better your company’s ability to handle short term obligations. A ratio with a value less than 1 may mean trouble ahead.
- Quick ratio. This measures how much is available in liquid assets, including cash, accounts receivable and marketable securities to cover current liabilities.
- Gross profit margin.To determine this financial ratio, take total revenues and subtract costs directly related to sales (the cost of goods sold) as shown on the income statement. Then divide the remainder by total revenues. The result is the amount of each dollar in sales that is available to cover overhead and earn a profit.
- Return on assets. This financial ratio, taken from the balance sheet and income statement, measures how efficiently assets are being used to generate income. You calculate it by dividing net income by total assets.
- Inventory management ratios. These measure whether liquidity or profits are being hurt by excessive inventory. Similar ratios are used to uncover problems with payments and collections.
If you find weaknesses in any of your financial ratios, here are some ways to fix them. For example:
- Low liquidity. Collect accounts receivable faster, delay purchases to reduce accounts payable or take out a long term loan to refinance short term debt.
- Low equity. Decrease debt, retain more earnings or invest additional cash in your business.
- Low gross margin. Adjust pricing or reduce selling expenses.
- Low return on assets. Increase revenue and reduce expenses.
The main point is, you can’t address a situation unless you’re aware of it. If you don’t have a good handle on your financial statements and ratios, you’re flying blind — and you may not see a problem coming until it’s too late.
Software packages like QuickBooks make it easier than ever to create and update ledgers, and high-quality CPA services are widely available. The American Institute of CPAs® can help you find a CPA. The U.S. Small Business Administration has tips on how to prepare and understand financial statements. City National Bank also offers assistance in this area, so be sure to include us as you build your network of valued advisors and consultants. Call us at (800) 773-7100, request that a Relationship Manager contact you.