page updated on June 06, 2016

Financial Statements are the Scorecards of Business

When you run a business, you become more than a mere technician. Your work is now far more than knowing how to build a cabinet or to bake bread or to write a computer program. Your work is building a successful and sustainable business.

The most successful business owners know how to measure and manage their businesses by examining and exploring their financial statements. This discipline—regularly collecting and reviewing this information—can help save a business in trouble and make a well-run business even more efficient.

Understanding Your Financial Statements

Your work as the owner of a business is to understand this information or hire someone trustworthy who does.

A good financial professional such as your tax advisor, banker, or CPA can help. Other professionals in your line of work, or found through professional networking organizations, may give you good advice.

Of course yearly reviews are important. Your banker can review these and hold you accountable. (If your banker doesn't love you for providing them, find a banker who does: bankers understand the nature of business and risk and good bankers want to help ensure that their investment in you is wise.) Be sure to perform these reviews and checkups on time: prepare your tax information by the end of the year, look over the previous year as close to the start of the year as possible, and review monthly data as soon as you have it.

This diligence will help you see problems and, above all, manage waste. The sooner you can spot something strange, the sooner you can fix it. It's better to have almost right information as soon as possible than to wait for perfect information and delay important changes. (You can always update the review as you get better information.)

The most important lesson to remember is that cash flow is vital to your success. Tomorrow only matters if your business can survive today. This is a fundamental principle behind your balance sheet: it shows your financial health.

Projected Financial Statements

Again: cash flow is vital to your business. You can be highly profitable on paper, but if you're out of cash at the moment, you're in big trouble. Most successful businesses can even predict their cash flow. A good accountant can help you make a rolling six month projection. You won't believe how valuable this can be.

Current Ratio

One measure of financial health is the Current Ratio. This is the total value of your current assets divided by the value of your current liabilities. The higher this number the better: if you had to sell everything to pay off your debts, could you do it? How much of your business would you have left over if you did? A ratio of 2:1 is healthy. Anything below 1:1 is dangerous.

Debt to Equity Ratio

Another important measurement is the Debt to Equity Ratio. How much are you in debt? Divide your total debt by your total equity. If that ratio is less than one, you're in great shape. (If that ratio is greater than one, it's not necessarily a bad thing. It does mean that someone else really calls the shots for your business: if they call in your debts, they're in charge.)

Measuring the changes in your Current Ratio and your Debt to Equity Ratio over time will give you great insight into your business. If all is going well, your Current Ratio will be increasing and your Debt to Equity Ratio will be decreasing. When those numbers change, pay attention!

Accounts Receivable

Managing your Accounts Receivable is fundamental to managing your cash flow. When someone owes you money, you have to collect it! Keep track of how much money you expect to come in every month, and keep track of how old those accounts are: the longer you go between billing someone and collecting, the more dangerous. If you can, get your Accounts Receivable age down to a month. (This of course depends on the contracts you have with your customers. The more you can standardize on a contract, the better. This gives you better standing when it comes to getting paid and it makes your business look more serious.) The Big Sale only means something if it produces a Big Payment.

Inventory Levels

If your business includes inventory, measure it carefully. Inventory does count as an asset, but it's not nearly as nice as cash: you have to store it, you have to pay for it, and you have to sell it to turn it back into cash. If you have to liquidate it in an emergency, expect to get half price for it—or less. Great companies turn over their inventory frequently, such that they don't keep extra products on the shelves for very long. They also take stock of their inventory relentlessly. If you can do this monthly (divide it into discrete pieces!), so much the better.

If you have Accounts Payable, watch these numbers closely. They'll tell you how well you manage credit. Paying your vendors on time will keep them happy, and being able to pay them on time demonstrates financial stability.

As with any number you measure, pay attention to the trends. Tracking things like the age of Accounts Receivable or any of the Ratios or Inventory Turnover time on your monthly financial statements lets you compare to the previous month or the same month in the previous year. What's changing? Why? Are the numbers going in the right direction?

If you make financial projections—such as a projected budget—include those numbers on your financial statements. This will give you goals to work toward in the coming year. It will also help keep your goals reasonable and well founded.

Remember that you can improve profitability in only three ways: decrease your expenses, increase the margin on the products sold, increase the volume sold. While most people focus on the latter, the former is more effective. (A 1% reduction in your costs has a much greater effect on your profitability than a 1% improvement in sales volume.)

Profit and Loss Statement

Use your Profit and Loss statement to manage the strategic direction of your business. This has many valuable pieces of information. If you add a column showing the percentage of sales each row represents, you get a great idea of where your business spends its money. Watching the trends over time in this column will help you decrease costs.

With this information in mind, pick a couple of key indicators to focus on in the coming year. Add these to your monthly reviews. Pick the best opportunity for cutting costs as your top indicator and focus on it relentlessly.

Above all, remember that when something isn't working, the solution is to work differently. Working harder will only burn you out and keep you going the wrong direction. Measure, then change.

Even though you may think of yourself as a carpenter, a plumber, a doctor, or a programmer, you're fundamentally a businessperson now. Upgrading your knowledge by investing in your understanding of your finances is inevitable, if you wish to succeed.

Solutions to Small Business Cash Flow Problems

Schell's book doesn't explain how to fix your cash flow financing problems. It goes one step better; it explains how to identify cash flow problems in your small business before they become problems. He hints at one possible solution; if your financial statements are in order and if you can demonstrate that you have a viable business, opening your books to your banker or lender will make you look like a much better candidate for a business cash flow loan than a business without its books in order.

Business Finance is Vital to Your Success

Business isn't easy. Small business is downright difficult. Cashflow management is essential to your survival and success. Unless you know where your money is going and why it's going there, you can't make good plans to invest, to focus, or to reduce. Schell's book is simple, readable, and easy to understand. Putting his rules and guidelines into practice won't always be easy, but they will put your business back on the right track.

Understanding Your Financial Statements

Jim Schell

ISBN: 0970933517

Even a simple review of your business's financial statements can bring you greater success. Jim Schell's short book is pithy and valuable to anyone who owns a business. Highly recommended.

cover image for Understanding Your Financial Statements