Time to Scrutinize Your Business Financial Details

Changing economic conditions are the greatest stimulus to urgently determining the best course of future action. To identify the most crucial matters to address, you must first know how to read and understand your business financial statements.

Assets & Liabilities

The collection of reports comprising business financial statements provides a complete picture of the cash flow and overall condition of your enterprise. Most importantly, the balance sheet is a reporting of business assets and liabilities, with the difference between these two factors being the equity you’ve built over time in your business.

Too many business owners only examine the income statement for revenue and profit. Those factors transform into a deeper meaning by scrutinizing key elements on the balance sheet. A major detail to easily spot as a red flag is higher liabilities than assets. This means your business owes more than it owns. Even if this troubling condition does not exist, you want to evaluate if your business is headed in that direction. This is simply accomplished by comparing over time the ratio of debt to equity. A rise in this metric signals potential problems ahead.

A corollary issue uncovered by the balance sheet is the expansion of accounts receivable or inventory relative to sales. Having too much in uncollected accounts receivable can mean insufficient cash for timely payment of billed expenses. Although possessing enough inventory is important, having too much wastefully ties up your cash. Trends for accounts receivable and inventory can also be assessed by ratios. These determine the number of days you have on hand of accounts receivable and inventory based on recent sales. Since these calculations demand a little experience in analysis, your accountant can help with the math. All you need for this exercise is accurate up-to-date bookkeeping.

Revenue & Expenses

The income statement is the familiar report of revenue and business expenses. Many small operations keep their books on a cash basis, meaning the income statement reports revenue when received and expenses when paid. If your enterprise is accrual-based, it records revenue when customers are invoiced and expenses when bills are received. An accrual-basis operation will, therefore, also need a cash flow statement.

Declining revenue is obviously bad. But a temporary period of falling sales can be survived with some expense reductions or borrowing money. Look for unnecessary expenditures that can be reduced or eliminated. Your business may be stuck with large costs for space and personnel, but other categories are ripe for cutting back. Lower spending for multiple small categories can add up to substantial improvement in cash flow.

Deciding whether taking on more debt is sound brings you back to the balance sheet. If your business has plenty of equity, having more liabilities will not harm the operation’s financial strength. The other consideration with borrowing is assuring sufficient cash flow for loan repayment. Finding your cash flow number, which is not necessarily the business profit, permits you to calculate the sufficiency of incoming funds to cover the sum of all loan payments. That’s another simple ratio but also a factor to consider with input from your accountant.

Have a Meeting with Yourself about Cash Flow

When you perform all the executive-level functions at your business, the important role of officer meetings, such as those at large enterprises, is overlooked. But a few intervals throughout the year are ideal for requiring your inner CFO to describe cash flow results to an empty room of imaginary executives. You’ll force yourself to articulate key money matters. This prevents them from remaining mere abstract concepts in the dark recesses of your mind.

Cash flow is different than profit. Cash flow from operations ignores uncollected revenue and unpaid expenses. These elements are identified on a cash flow statement as the changes in accounts receivable and accounts payable. You then add or subtract other factors from operating cash flow. Interest expenses and depreciation are added. Costs for depreciable assets are subtracted. Loan payments are also subtracted. Any money that’s borrowed or that you put into the enterprise as an owner adds to cash flow.

A cash flow statement is a key report, but some smaller operations already maintain cash basis bookkeeping. In those cases, cash flow from operations can be identified from the cash basis income statement, which already excludes uncollected income that’s still in accounts receivable and unpaid expenses that are still in accounts payable.

Comparing cash flow from one period to another delivers insight into the overall financial health of the business. Although rising cash flow is generally good, building too much cash may indicate excessive borrowing, not paying bills on time, or ignoring replacement of old equipment. Short-term cash flow dips are not so bad if they result from increasing revenue that’s not yet collected.

Setting, Measuring and Evaluating Business Goals

Unlike waiting and hoping for a change in unfavorable weather, adverse business conditions are within your power to alter. The process requires knowing the sources and causes of difficulties so that they may be corrected. Unfortunately, access to necessary data is often compromised by an entrepreneur’s focus on ordinary daily activities. The solution is establishing a habit of setting goals and having a desire to identify the progress you’re making.

Setting Measurable Business Milestones

Current goals should align with the larger vision you had when starting your business. Objectives for this year should be measurable targets accompanied by action steps to accomplish them. When your actions don’t produce the expected goals, making corrections is crucial.

Short-term goals are set by working backwards from your big vision. You want to decide the measures to achieve along the way to your ultimate long-term aim. Decide what spending and cash reserves you’ll need in the future to have the earnings you desire. These factors embody the planned scale of operations. Then you can set near-term milestones. Finally, you identify the routine activities that seem most conducive to reaching those milestones.

Income Statement Evaluation

Your big vision may be something out of your wildest dreams. But current goals require a dose of realism. Obviously, resources of time and money are limited. Your burden is using them optimally. The milestones are how much money you can derive from the available time. Scrutiny of the business income statement conveys not only this realized profit but also how you achieved it.

Revenue on the income statement informs you of how much you were paid for your time. Each of the expense categories reveals what you had to spend for earning the revenue. This information uncovers expenditures that can be reduced by a revision to your action steps. Changes in spending behavior can increase the profit resulting from the same amount of revenue. But altering the wrong expenses may adversely impact revenue. Continuous examination of income statement details shows you which actions are best at meeting your milestones.

Balance Sheet Examination

Evaluation of business milestones doesn’t end with the income statement. Examining the business balance sheet is also a key step for refining actions to meet your goals. Balance sheet items identify many of your milestones. For instance, the amount of assets (especially cash) that your business retained from its earnings is on the balance sheet.

Remember also to check the liabilities on your business balance sheet. Some of the cash and other assets may have been acquired with borrowed money. At the bottom of the balance sheet is business equity, which is the difference between business assets and liabilities.

In the equity section is an account for the funds you have personally withdrawn from the business. This is a negative amount that reduces the earnings retained by the business. When you have a long-term vision that necessitates reinvesting earnings, your near-term goal is building retained earnings. Evaluating a milestone for retained earnings is an example of a measurement to regularly scrutinize. When you get off target, a revised action plan is desirable.

Accounting for Small Business Debt

A business debt that you can’t collect is certainly costly, but how you account for this unfortunate situation depends on several factors. Debts are typically invoices to customers that will not be collected.

If you never received money that you expected, the loss is not the same as theft. Your business cannot lose cash that it never had. For this reason, a cash basis accounting system does not have any debt expense. Cash basis only counts income when payment is received. A cash basis business does not have any accounts receivable in its bookkeeping. Receivable amounts were never added because uncollected invoices are not yet counted as income.

Creating a receivable only occurs in bookkeeping that adds income using accrual basis. Accrual basis accounting counts a sale as income when it’s invoiced. If your business is accrual basis, the previously recorded income for an uncollectible invoice amount must be offset by a debt expense. The expense increase is balanced against a reduction to accounts receivable.

Most accounting software produces financial statements for either the cash or accrual method. Debt expense will only appear on the accrual income statement since only accrued income will include uncollected accounts receivable. The cash basis reports are unaffected. They show no debt expense because the expected income is already absent on the financial statements.

Costs associated with invoiced work represent cash lost for both cash basis and accrual basis. These expenses are captured regardless of whether customers pay the invoices you sent. But that’s an issue for your accounts payable system, not accounts receivable.