For entrepreneurs, “Know your money” means understanding financial statements. Many business owners treat them as a necessary evil only useful for loan applications or tax returns, but financial statements can also provide operational information to entrepreneurs who take the time to learn how to read them.
The two basic financial statements are the balance sheet and the income statement, sometimes called a profit and loss statement. The balance sheet shows the company’s financial position at one specific point in time while the income statement shows the income and expenses of the company for a period of time.
The balance sheet includes assets (what the company owns) and liabilities and equity (what the company owes). Assets = liabilities + equity and both assets and liabilities are further divided into current and noncurrent items.
Current assets include cash, receivables, inventory and other current assets like customer notes and prepaid expenses. These are assets that are expected to be converted to cash within the next year. Noncurrent assets are the fixed assets, that is, property and equipment, and other assets that are not expected to be converted to cash within the next year.
Current liabilities are the amounts the company owes to others within the next year and include payables, accrued expenses, and the portion of long-term debt due and payable within the next year. Noncurrent liabilities include loans and leases owed to others along with amounts borrowed from the owners that are not included in equity. Equity or net worth is equal to the total of assets minus liabilities. It is the amount owners have paid into the company plus the net income earned for all years the company has operated.
The balance sheet can provide useful information like how efficiently the company is using its resources (turnover), how easily the company’s resources can be converted into cash to pay creditors (liquidity), and the degree of financial risk the company or its creditors face (solvency).
In turn, the income statement shows how profitable the company is. It is typically prepared in steps showing income first, then deducting direct costs of sales to arrive at gross profit, then deducting other selling and general expenses to determine the net income, or profit (or loss) of the company for a period of time. Various profit percentages can be derived directly from the income statement. Return on assets and return on equity are two other ratios that provide how well the company is using its resources to produce more income.
Learn to understand not only your financial statements but also the operational information they provide. Design your financial systems to assist you in intelligent decision making and you will know your money. From there, the sky’s the limit.
Bill Saylor is NCET’s Vice President of Finance and a CPA with J.A. Solari and Partners, LLC.
I wrote recently in this column about Nevada’s growth in the aerospace, clean energy, software and financial services sectors. Today, we’ll look at some new areas that offer equally exciting opportunities.
