In business, two of the most commonly used words are: profit and loss. The size and the nature of the business may not be important here as the underlying principal of making profits while reducing losses is the fundamental piece that completes the puzzle of the whole business.
But how do businesses actually keep track of the profit and loss that they experience every month?
The system of recording this profit and loss is embedded in the way a business manages its financial documents. While these financial statement documents may be quite complex and varied for larger firms, they are comprised of only a few parts for a small business.
Do you know the reason why small businesses usually fail? They fail because the owners fail to keep tabs on firm’s cash flows as well as financial position.
And of course when they fail to make proper decisions based on these cash flows and financial position.
If you own a small business, here is a list of 3 financial documents that are most likely to give you a complete picture of your financial position and where you stand as a business. Getting to know the basics of these financial documents will charter a future course of action that is likely to benefit your business.
Think of the balance sheet as a snapshot of the current financial position of your business. Although many investors skip the balance sheet part and go straight to the income statement for gauging the financial worth of a company, balance sheet is what they should start with. Why? Because balance sheet is a condensed and summarized version of your business’s fiscal health as it contains key financial information at a given date.
But what does a balance sheet contain and why is it important?
The balance sheet of a small business contains the following components:
- Business Assets: Assets are what the company owns at a given point in time. And this ownership feature is not limited to what the business owns only, but also what it controls and possesses such as tangible assets of plant and machinery and intangible assets of patents and copyrights. Both of these items are in possession of a small business when it is operating as a registered company.
- Liabilities: the obligations of a firm or what the firm owes is mentioned in the liabilities section of the balance sheet. It shows what a business owes to its suppliers, customers, banks, etc. and what its obligations are such as borrowed loans and payables.
- Owner’s equity: this last component of the balance sheet finally addresses what is left for the owner(s) after the assets that the company possesses are used to pay off the liabilities that the company owes. After all the obligations are paid off, the remaining assets are the owner’s share. And it is up to the owner to decide what to do with these assets, retain them with himself or re-invest them back into the business.
Think of your income statement as your business’s report card.
While balance sheet shows a snapshot of your business’s financial position at a fixed date, an income statement (also called profit and loss statement) provides an overview of how your small business is doing over a time period.
An income statement shows how profitable a business is by giving an estimate of the expenses and the cost of goods sold. You can calculate the profitability of your business by subtracting your expenses from your total revenues to generate an estimate of profit or loss position.
The bottom line or net profit (or loss) will determine what expenses you should really be focusing on and what expenses you should curb as unnecessary. Where a balance sheet shows what you owe to others, an income statement shows how your business is doing in terms of the losses or profits it is generating—how much cash is left to grow your business and to cover your debts.
When an investor looks at your business plan, he will most probably refer to your income statement to assess what you are spending on and how much you are spending.
Statement of cash flows
From a cursory glance, your business might be generating profits, but look closely at your statement of cash flows and you will find out that’s not the case.
Even if your small business is drawing up profits, it might be facing difficulties in managing its cash. This is because cash doesn’t necessarily flow into your business the same way that it flows out.
Unlike both balance sheet and income statement, statement of cash flows compares between two consecutive time periods such as beginning and end of the month, dividing the cash flows into operating, investing, and financial cash flows.
The complete cash picture is displayed in this statement of cash flows, indicating how much cash your small business is actually generating to stay afloat.
Drawing it up all together
The 3 financial statements mentioned above give a complete account of the financial viability of your business, making it easier for you to take decisions based on the numbers contained in these documents.
Usually drawn at the end of each accounting cycle, these financial documents are more than just documents for your firm. They are a means to expand your business if you are planning to localize in other markets and this will be done through the help of a professional localization partner.
Managing a business is not an easy task. But once a business learns to interpret these financial statements accurately and take strategic steps based on these statements will it be able to make a worthy “profit” in the market, and only then will it be able to stay ahead of the competition.
Many small businesses burn and fizzle out in their infancy—and the reason is an inability to make decisions based on these financial statements. The real challenge, therefore, is to comprehend and interpret these financial tools in a way so as to make careful and analytical decisions for your business—irrespective of the nature of your small business.