Question:
Every month my bookkeeper sends me my profit and loss statement, which I regrettably do not fully grasp. What do I need to know — from terminology to concepts — for a better handle on these things?
A: It’s not uncommon for business owners caught up in their daily business to not take the time to understand the financial resources at their fingertips. Below are the three financial statements, interconnected, that can help you stay financially focused:
- Income statement: This measures profitability of your business relative to sales generated, less expenses over a period of time.
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- Your sales reflect your product demand, pricing strategy and advertising effectiveness.
- Gross profit represents your sales, less cost of goods sold, and measures your direct profit contribution for each sale dollar.
- Gross margin (or gross profit/sales) is a key efficiency metric that calculates how well you’re managing direct costs as a percentage of sales, easy to track over time.
- Overhead identifies costs used to frame-up your business, subtracted from gross profit to arrive at your net profit.
- Net margin (net profit/sales) tells you how well you are managing your overhead relative to changes in sales.
- On the balance sheet: This statement is a measurement of risk at a specific point in time. It highlights your assets (what you own) against liabilities (what you owe), plus equity (your residual interest in the business). This statement is essential for evaluating the following:
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- Liquidity: Sufficient current assets to service current debt obligations.
- Financial stability: Growing retained earnings signals the business is retaining a portion of their net income for future use rather than owner distribution.
- Capital structure: Favorable debt/assets ratio (<.5) demonstrating the business is financed more with equity than credit.
- Cashflow, the king: If you could only have one statement, this is it. Yes, “cash is king.” It measures the amount of cash that is being generated and consumed by your business. It takes your net earnings (from the income statement) and combines changes in your balance sheet accounts to help you understand how your cash is used and where it is sitting. It’s truly the one-stop-shop statement.
If you need further assistance with your financial statements, we encourage you to come see us at Central Oregon Community College’s Small Business Development Center for free consultations.
About the Expert:
Dave Grotjahn is a business adviser with Central Oregon Community College’s Small Business Development Center. He is a retired senior finance leader from Boeing Commercial Airplanes where he led investor relations, estimating & pricing and financial planning teams across many programs.
The SBDC offers free, confidential professional business advising and a variety of low-cost courses to help entrepreneurs through the business lifecycle.
