When I coach new entrepreneurs they tend to have a pretty sketchy understanding of their financial statements. They usually know the P&L best. That’s where you find sales and that all important bottom line figure. We use the term so much that sometimes we forget that the bottom line is actually the bottom line of your P&L. But once you get to the balance sheet most owners are lost and they’ve heard about the cash flow statement but it’s more a distant rumor than anything else.
I’m working on some analogies to demystify these statements. Forgive me if they are a bit belabored and let me know if you have better ways to describe them. I think the Profit and Loss statement is best thought of as the story of your business. How do you get from sales all the way down to profit? The problem with the story is that the person telling it gives you way to many details about all the characters and keeps going down rat holes so that the listener struggles to follow the plot.
I use Greg Crabtree’s simple numbers framework as a kind of Cliff Notes to the very confusing story my P&L is telling. When you focus on labor or another big cost it helps to see it grouped all in one place rather than spread across accounts. You can then see how big a percentage of revenue that expense is and how it has varied over time. When you do this, you get the real story of your business. Marketing costs are a major expense for some companies particularly those that rely on online advertising. You can isolate you ad spend and then compare it to revenue over time. Do you see increasing returns? Do you see diminishing returns? Do you see no relationship at all? Each of those possibilities is a different story of your business.
The BS
The fact that a balance sheet is abbreviated as BS should tell you something. Business owners like to ignore this statement because it is even more confusing than the P&L and it doesn’t tell you how much money you made last month. So what’s the point? Also what is shareholders equity and why do I care?
A good balance sheet is like a treasure map but this is a blog about small business so let’s be realistic. It is more like the map of a minefield. Uncollectable accounts receivable, debt, and other liabilities are all there. It’s the BS because many of the assets on it aren’t revalued when market conditions change. Same goes for accounts receivable. Just how many of those 120 day past due invoices are going to come in? Caution is advised.
On the more positive side, cash is on there as well but unfortunately there’s usually too little of that as most companies are undercapitalized. Again I turn to Greg Crabtree who recommends you have two months of expenses in cash on your balance sheet to cover downturns. But don’t go crazy. Too much cash is bad as well, especially in inflationary times. Money should be working to replicate itself through investments. You need enough cash to let you sleep at night but not so much that you are slowly impoverishing yourself from inflation.
The Truth Serum
I have to admit I don’t really look at my cash flow statement all that much but it can tell you some important things, especially in an acquisition. Cash flow can tell you whether the company is making money from its core business or whether its selling off assets or equity or making money from non-core activities like loans. If a company’s cash balance goes way up but it’s from a one time sale of an old machine it doesn’t need or a piece of land it owns but doesn’t use, you’ll be getting a distorted view on the BS. The cash flow statement lets you see where the cash came from and where it exited to.
In general, I find reading financial statements to be a tedious task but if you learn what the core purpose of each statement is and you summarize the key data, they can be fascinating. If I look at you cash balance on you BS against monthly expenses on the P&L, I can see how lean you are willing to run your business. I can see your appetite for debt and whether you balanced that against assets. I can see how effectively you manage your labor and what the trends are over time. It’s worth getting a little more comfortable with you statements and to learn to summarize them in a way that’s digestible.
That’s it for this week,
Alan