Recently, I talked about the importance of considering cash, not just the profit and loss statement, when running an organization. As a result, I was asked by a business owner: “What financial reports should I be looking at?”
Again, I am not an accountant. But I work closely with a trusted team of seasoned accounting professionals. And I highly, highly recommend that any business owner takes the time to work with a trusted accounting professional.
They are not all created equally, so take your time and find someone that you get along with, and answers your questions in a way that makes you feel as though they will be an awesome partner in helping you grow and sustain your business.
Even though, as business owners, we're not accounting professionals, and we're not expected to have the depth of knowledge that accounting professionals have, it's still essential for leaders to understand the basics of accounting – the basics of financials – to be able to make financial decisions and regularly evaluate the company's financial health.
Without that basic understanding, then we're ultimately letting others make those decisions for us. And I don't think that's a good idea.
So, what should a leader really know?
Well, the most basic “Accounting 101” of what we should know to get a good overview of the company's financial health starts with three essential reports that work together.
The first one is the profit and loss statement also known as an income statement. As the name implies, this is where you see if you're profitable. It’s also where you see what your income and expenses are like broken down by category. And that is also where you see if your revenue or expenses are unusually low, unusually high, etc.
The second one is the statement of cash flows. This one is to help you understand what happened with your cash. You see what came in, what went out, and you also get to see whether it's going up or down. So what's happening with the cash.
The third financial report that complements the other two is the balance sheet. Generally speaking, this is where you keep an eye on your assets. So you'll see your cash, you'll see who owes you money, what equipment assets you have, and you're also going to see your liabilities. This is where you’ll see whether you have any loans, who you owe money to, if you owe money on the credit cards, etc.
And, as part of that, you are also going to see your equity. And it includes what's called shareholder distributions and retained earnings – which at its most basic is also where you can see whether you have money to reinvest in the organization.
Now, the risk of this is that some may look at these retained earnings and think they have all this money to reinvest but just because you have this big beautiful number in your retained earnings doesn't mean that you have the cash on hand. And so that's why you really want to work with these three reports together.
Once you are familiar with the basics of these three reports, then you can start adding comparatives to dig deeper into the data.
You have your basic information of how the organization is doing. You can see whether the organization was profitable last month, for the quarter, for the year. That's one aspect.
You have your cash flow statement, okay, what's happening with the actual money. Because even though you have all kinds of profits, you may not have received that money and your cash may be low.
And then you wanna see what’s happening over time. Then you look at your balance sheet and then you see, for example, that overall the organization has been growing. There is more money to invest, and all those things.
After looking at that big picture, you want to dig into those three reports.
Again, if you're really not familiar with them, do spend a little bit of time reviewing all the elements on it. Make sure you understand every single line that's there. If you don't understand every single line that's there, ask your accountant. That's why they're there.
And if you have a really good accounting team, they will be happy to explain it to you. How many times have I gone, especially earlier on: “I'm sorry, I don't understand this thing. What does that mean? What does that mean?” And, at the very beginning, when you start digging into these reports, it gets a little overwhelming because there are a lot of terms. But as time goes by, as you get used to them, then you can actually get more minute information because your questions become a little bit more complex as opposed to just the basics. A really good accounting team will be your accounting partner, and they are going to help you understand these reports so that you can make better financial decisions.
Once you understand the basics, then you will want to add some comparative components. Of course, they're not all the same for the reports, but, for example, one of the things that I feel is really useful is looking, let's say in my profit and loss statement, at the “percent of total income”. If the revenue is relatively stable and then I'm seeing this rapid increase in percent of total income in my cost of goods sold, I’ll dig into what's going on there. Or if I see this rapid increase in expenses percentage-wise relative to the income, I’ll dig into what's happening there. And so it really helps pinpoint potential issues.
Once you’ve assessed that, you will also want to look at performance in relation to the previous period, let's say the previous month or the previous year. Comparatively to last year, month to month, how are we doing? Profit and loss for the year, this year for the same period last year. How are we doing? How are we comparing? Are there trends? It's extremely useful for spotting if your business has “seasons”.
Even if you're not a traditionally seasonal business you may still notice that there are certain slow down periods or certain periods where it really ramps up. And that will help you identify those periods as well.
Spotting those trends also helps you plan for your recruiting and other operational aspects.
Although, yes, these are financial reports, they still tell the story of your business. Which is why you really want to spend the time to understand them.
Another comparative I find useful is percent/dollar amount change. Then I can see at a glance percent wise and dollar wise what was the change from perhaps the previous period. It helps spot trends in expenses. It helps spot trends in the cost of goods sold. It helps spot isolated issues. Or at least draws your attention to items to keep an eye on. They may turn out to be isolated incidents or something that needs to be addressed.
Of course, as I mentioned several times, remember that a trusted accountant is an invaluable partner in helping business leaders understand the story that the financials tell.
And as those leaders deepen their knowledge, as we begin to deepen our knowledge and really understand what is happening, what those reports are telling us, then we get better at reviewing these reports.
We get better at understanding what's happening, and we get more benefit from meeting with our accountant because, again, our conversations are more in-depth because now we're no longer completely lost because we don't know what this term means.
Get comfortable with these reports. And, as you have more and more in-depth conversations with your accountant, that usually turns into a more informed strategy and you make better financial decisions for your organization, which leads to a more resilient business.