Basic Financials 101 – Critical Information for Small Business Owners
I remember a few years back, meeting with a new client who insisted he didn’t need me to provide him monthly financial reports, saying “If I’m making money on every job, and there’s cash in the bank, then I must be profitable!”
… Dude. This attitude is one reason that more than 50% of new small businesses are hard pressed to make it past their first couple of years.
Even after managing the accounting for SMB’s for nearly 20 years, I am still amazed at how many don’t clearly understand the importance of basic financial reports. After running into this problem enough times to want to scream from the rooftops, I took some time to reflect on why this might be the case. As it turns out, the most common reason SMB’s have this problem is because they don’t fully understand how to read these reports, or what they really mean.
Why don’t they, though? Oftentimes, they have an improperly set up an accounting system with an overabundance of GL accounts. Do you know how many chart of accounts I’ve seen with an income account for every. single. item and customer? Too many. One of the other top reasons is inaccurate accounting. Remember, garbage in = garbage out. This is often the result of having an under-qualified person managing the day to day bookkeeping. Just because your uncle or sister in-law needs a job, doesn’t mean that they’re the right person to be handling these critical business tasks.
Don’t worry, though, I’m here to help! In this five part series, we’ll take a look at the five basic reports that every business owner should read and the story they tell about their business. We will explain how they relate to each other, and why each of them only tells a small part of the bigger picture. Hopefully, by the end, you will have a better understanding of how to more effectively run your business!
Basic Financials 101: Part 1 – The Profit & Loss Report
This report can also be referred to as the Income Statement or Statement of Activity. Doesn’t matter what you call it, this report breaks down income and expenses , what you received for the products, and service that you sold and the expenses that you incurred. This report is usually run for a period of time that is relevant to the business, such as monthly, quarterly, or annually. It is divided into three main sections in the following order:
- Income – This is the amount of money you receive for sales. It might be broken down by general types of items you sell or service that you provide. This does not include sales tax if you collect it.
- Cost of Goods Sold (COGS)– These are the expenses directly related to sales (for example, If you buy and sell widgets, the cost of purchasing the widgets that you sell is a COGS). This would include the cost of raw materials and labor if you produce the product.
- Expenses – These are the expenses that you incur to run your business. They are costs like rent, utilities, office supplies, and insurance. Oftentimes, these are considered overhead costs. Some people refer to these expenses as “what it takes to keep the doors open and lights on.”
- Gross Profit – This is the sum of your total income (what you received for goods and services sold) less your COGS (what it cost to purchase or make the items or services you sold). This DOES NOT include your overhead expenses, by the way. [Income – COGS = Gross Profit]
- Net Income – This is the bottom line! Gross Profit less expenses. This shows how your business performed for the period selected for the report. [Gross Profits – Expenses = Net Income]
Here’s a handy visual for what those terms look like on paper!
PLEASE Don’t confuse net income with money in the bank. IT IS NOT THE SAME. In Part 2 of this series we will look at the Balance Sheet report and explain other factors that affect cash balances.