April is Financial Literacy Month, and if you’re looking to improve your understanding of small business finances, we’ve got you.
If you’re like many entrepreneurs, you have a general understanding of income vs. expenses. You know where to look on your financial statements to see how much cash you have in the bank or what your net income is. However, you may not know how to use the financial data you have to its full potential.
When used wisely, your business’s financial statements become a tool for forecasting revenue, deciding when to open a new location or introduce a new product or service, taking advantage of valuable tax deductions, and much, much more.
In this guide, we’ll provide some basic financial education for small business owners to help you understand how specific financial statements can inform your decision-making.
Additional resource: Bookkeeping Basics for Entrepreneurs
Financial literacy for small business owners: an overview
Financial statements are like a dashboard for your business. They tell you what your company owns and owes at a specific point in time, whether your operations are profitable, and how much cash flows in and out of your business. You may need them as part of a business plan for your startup or to get approved for business credit.
Let’s look at each of the three main financial statements your business needs and the purpose each serves.
A balance sheet shows your business’s assets (what it owns) and liabilities (what it owes) at a specific point in time.
When you subtract liabilities from assets, the difference is shareholders’ equity. Shareholders’ equity shows how much you (and your business partners, if you have any) have invested in the business—either by investing cash and other assets into the business or by retaining earnings of the business over time.
Ideally, you should have more assets on your balance sheet than liabilities, as this indicates a positive net worth.
Other important information you can gather from your balance sheet includes:
Liquidity. Divide your company’s current assets (such as cash, accounts receivable, and inventory) by its current liabilities (such as accounts payable, credit cards payable, accrued expenses, and short-term debts). The result is your current ratio. If your current ratio is less than 1, this is a red flag that you could have liquidity troubles. You may need to invest more money into the business or get a small business loan to keep the company afloat.
Ability to distribute profits or pay dividends. Do you have a lot of cash on hand and few debts? Distributing that surplus in the form of distributions or dividends can give you and your business partners a return on your investment.
Ability to reinvest in the business. You can also reinvest excess cash into the business by purchasing real estate or equipment.
Assets that can be sold or retired. Do you have assets on your balance sheet that you no longer use? Selling them for cash can improve your business’s liquidity.
An income statement, also known as a profit and loss statement, shows what your company earns (revenue) and spends (expenses) over a period of time — usually a month, a quarter, or a year.
When you look at your income statement, you likely look at your net income, also known as your bottom line. This tells you whether your business earned a profit or suffered a loss. But there’s a lot more to discover in your income statement — especially when you use it in conjunction with your balance sheet.
How this period compares to last period. Looking at your income statement for one month, quarter, or year can be useful, but a comparative income statement is even more informative. This type of statement shows the results of two or more accounting periods in separate columns, giving you a view of how the business is performing over time. For example, are revenues down? Did your cost of goods sold increase significantly from last year to this year? Why have salaries and wages gone down when you expected them to go up? Comparing each line item can help you uncover troubling trends or errors within your financial statements.
Whether you have too much debt. Divide your company’s total earnings before interest, taxes, depreciation, and amortization (EBITDA) by the annual principal and interest payments on all loans. The result is your debt-service coverage ratio (DSCR), and many lenders use it to determine whether or not to give you a business loan. While each lender has its own requirements, loans backed by the U.S. Small Business Administration (SBA) generally require a DSCR of 1.15 or greater.
How efficiently you turn over inventory. For many businesses, keeping inventory on hand is critical for meeting customers’ demands, but having too much of the wrong inventory can lead to cash flow problems. Divide your average inventory by your cost of goods sold for the same period. The result is your inventory turnover ratio. For most industries, a good inventory ratio is between 5 and 10, meaning the company sells and restocks inventory roughly every one to two months. However, an ideal ratio for businesses with perishable inventory, such as grocery stores and florists, may be much higher.
How quickly you collect accounts receivable. Divide your average accounts receivable by sales for the same period. The result is your receivables turnover ratio, and it shows how quickly you collect the money that is due to you from customers who buy on credit. While a “good” receivables turnover ratio varies by industry, in general, the higher, the better. A higher number means your customers pay on time, and you are good at collecting receivables.
Cash flow statement
A cash flow statement shows how money flows into and out of your business over a period of time. It shows what your company is doing with cash (spending, investing, or distributing to shareholders), where that cash is coming from (operations, investing, or financing), and how much cash the business has at the end of the accounting period.
Your cash flow statement can tell you:
- Whether you have a positive or negative cash flow. It’s possible to have healthy revenues but be cash-poor. This can happen when you have too much cash tied up in inventory or receivables or are growing too quickly, which is draining your cash faster than you can bring it in. Any business can experience a cash flow crunch from time to time, but few can sustain negative cash flows in the long term, so this is an area you want to keep a close eye on.
Cash flow forecast
A cash flow statement shows where money came from and went in the past, but a cash flow forecast helps you predict the future by estimating cash coming in and going out based on past performance.
A cash flow forecast can help you determine:
When you may have a cash shortfall. If you’re going to have more cash going out of the business than coming in, it’s better to know sooner rather than later. This can help you plan for cash shortages by securing a business line of credit, adjusting the timing of payments to vendors, or speeding up receivables collection.
Whether you should pay for future initiatives with cash or a small business loan. You don’t want to sink all of your available cash into building a new location or purchasing equipment, just to run out of money and have to lay off employees. A cash flow forecast helps you plan projects and secure financing when needed.
How Bench can help
It’s totally possible to handle your own bookkeeping and prepare your own financial statements with the help of accounting software or financial statement templates. But chances are, you have enough responsibilities as a business owner. That’s where working with a bookkeeper comes in handy.
An experienced bookkeeper can prepare financial statements for you, so you can make financial decisions and keep tabs on the financial health of your business without spending hours classifying transactions and reconciling accounts. Plus, when it comes time to file your income taxes, you’ll know that your financials are 100% correct and ready to be handed off to your CPA or tax accountant.
Don’t have a bookkeeper? Check out Bench. We’ll handle the bookkeeping for you, prepare financial statements every month, and give you access to the Bench app where you can keep tabs on your finances.
Now that you have some financial knowledge fundamentals, you’re in a better position to review your financial statements and make more informed business decisions. If you need help, get started with a free month of bookkeeping.