Small business owners spend an incredible amount of time growing and running their businesses. To be successful as a business owner, however, it’s critical that you really understand your business finances.
When I start working with business owners, the first things I ask for are their profit and loss statement, their balance sheet, and their business tax returns from the previous year. These documents can show me exactly where my business owner clients’ finances stand and help them chart courses for the future.
I’ve seen some situations where this lack of understanding impedes a business owner’s ability to grow and prosper. So even if you have a good CPA — and as a business owner, you should — it’s imperative that you know and understand your financials better than anyone else.
Understanding your P&L
A profit and loss statement, more commonly known as a P&L or an income statement, is a financial statement that summarizes a business’s revenues and expenses. It shows how much income you’ve generated and where your money has been spent over a period of time, usually a quarter or year, and measures profitability over that time.
Comparing your P&L statements year over year or quarter over quarter will show you how your revenue and expenses have changed over time. If your expenses have increased but your revenues have not, your profit margin has shrunk. If the opposite is true, your profit margin has grown.
As your business grows, you may have some periods where you record losses instead of profits. P&Ls can show you if and when increases in operating costs or investments in new technology pay off, and when you’re financially healthy enough to assume greater liabilities or pay yourself more money.
Understanding your balance sheet
A balance sheet reports a company’s assets (what it owns), liabilities (what it owes), and shareholder equity, or how much the owners have invested.
For a company to pay for everything it owns, it must either borrow money or receive more investment from owners. Assets must equal liabilities plus shareholder’s equity. It is important to understand how the balance sheet is impacted by business decisions you make.
The balance sheet is also useful in computing your debt-to-equity ratio, which you compute by dividing a company’s total liabilities by its shareholder equity. The debt-to-equity ratio evaluates a company’s financial leverage — how much of the operations are financed through debt versus cash/assets. It also helps show whether shareholder equity would cover all outstanding debts if the company were to close down.
Unlike a P&L, a balance sheet represents a specific point in time. It is most helpful when compared to other periods of time and reviewed in conjunction with the P&L.
Make projections for your future as a business owner
Understanding your P&L and balance sheet is the first step in understanding your cash flow. Your P&L will show how much revenue your business has collected. It will also reveal your expenses, both those that are fixed and those that vary from month to month. When you compare a current P&L to an older one, it will show you whether your performance is improving.
Your balance sheet will reveal short-term and long-term obligations. These could include ongoing debt obligations, retirement plan contributions you will need to make, assets you plan to purchase, and more.
You can use these statements together to make short-term projections, like how much income you’re expecting over the course of the year and what your estimated profit for the year will be. You can even put together projections for your next 12 months and beyond. This can be difficult for business owners to visualize, but it’s easy one you understand your numbers. If you have multiple revenue streams, it can provide insight into which business lines are more profitable and where you may want to focus your money and attention going forward.
When I work with business owner clients, I often ask them to show me their year-to-date P&L and balance sheet. Then we review these records from the same period in the previous year. We go through these statements line by line to see which numbers are up and which are down. If expenses have increased, what has driven that change? If income is higher, how well does the increase align with projections?
Finally, we use these statements to set reasonable, well-informed goals for the coming months. We might focus on profit for the year and whether we should increase distributions paid back to the owner. We can also talk about how to leverage their equity or assets or add a liability to fund a planned expansion. If income is increasing, we try to figure out if that growth is sustainable.
You don’t have to be a CPA to understand your financials as a small business owner. The more time you spend reviewing your P&L and balance sheet, the more insight you can draw from them. That gives you the power to set concrete, achievable goals for your business’s future — and to understand how your personal finances might look as a result.