Many business owners can be apprehensive about their company’s balance sheet and income statement, but a few simple strategies can help even the most intimidated understand them and make meaningful decisions about company operations.
Balance Sheet Review
The balance sheet contains a summary of all assets, liabilities, and owner’s equity. Start your review by calculating the ratio of your current or short-term assets to your current or short-term liabilities. Current assets include cash, accounts receivable, inventory, and all assets that are not long-term assets. Long-term assets include real estate, equipment, and assets expected to last longer than 12 months. Current liabilities include all moneys owed to others that are due within the next 12 months, as well as the portion of long-term liabilities due within the next year. After you divide current assets by current liabilities, you have a ratio. A 1:1 ratio means you have enough current assets to cover your liabilities. A ratio greater than 2:1 is considered above average. If your ratio is less than 1, your current liabilities are too high and should be reduced. This important ratio is called the current ratio and is a reflection of your company’s ability to cover short-term obligations.
Compare each of the balance sheet’s asset and liability accounts with those from the previous month. Look for changes. Increasing cash is positive and means you are converting more of your assets to cash. Unless sales are also rising, increasing inventory values can mean you are letting your inventory creep up. Managing your cash, accounts receivable, and inventory is the most important way to keep your business’s working capital in good shape. Increasing accounts receivable can either mean sales are increasing or customers are paying slower.
Income Statement Review
The income statement shows how your company earned money and how money was spent during the most recent period (month or year). Often income statements show a year-to-date figure and a percentage of total revenue. The first value to look at is gross revenue. How does it compare to last month’s? Is there a solid trend of total revenue increasing or decreasing? Ask yourself what caused significant changes to this number, up or down. Could seasonality or a short month have contributed to a change?
Next look at gross profits, which is total revenue minus cost of goods sold. Look at the percentage. Does it look as you expect? Strong managers know how their gross profit margin is trending month to month and how high this margin has to be to cover the rest of the business expenses and earn a profit. The next category in the income statement is expenses. Scan them and first look at the items with the largest percentage numbers next to them. They represent your business’s largest expenses. Reviewing expenses from the highest to the lowest allows you to keep your priorities straight.
As you do your top-down review, consider why each expense is as it is, whether it is necessary, and whether you might need to spend more in a category that might bring more revenue, such as advertising or marketing. Remember, you have to spend money to make money.
The last item to review on your income statement is found at the very bottom of the chart. QuickBooks and several other accounting programs call the bottom line number net profit. If net profit is positive, your company earned money. Congratulations! If the bottom line number is a negative number, that means you spent more money than you made. To fix this problem, your company needs to increase sales, decrease expenses, or do a combination of both.
Successful managers are always learning more about financial statement review and how to improve their company’s bottom line. Consider continuing education training at a local community college or an Office of Small Business Development Center. These are located throughout the United States and are chartered to counsel and provide quality training for small business owners, managers, and other key personnel.
Sam Thacker is a partner in Austin, Texas–based Business Finance Solutions.