It’s always important to know your financial position and available cash in order to effectively continue your business.
Do you know whether your business is growing or not?
Understanding how much profit you earned helps you make critical business decisions. For example, when deciding to purchase a new equipment, you may want to know how much profitable revenue you have earned before investing a large amount of cash. Or maybe, you are renting a space and would like to purchase your own property.
The question for you would be: did you earn enough to make a big investment?
Knowing the financial position of your small business will help you improve your financial performance. Growing a business is not only about making sales but making profit that looks at the long-term sustainability of your business. It will be in the best interest of your business if you begin to learn how to read the numbers in your profit and loss statement.
If you don’t know how to read your financial statements, that’s okay.
Just read on as we break down for you the formulas and numbers you need to look at in your profit and loss statement.
Your mentor or business coach would probably tell you to seek professional bookkeeping advice from a trusted financial advisor. And it’s best for you to call on an financial advisor specializing in small business bookkeeping as they understand better what your small business needs. The bonus, they can also help you with federal and state requirements.
It's not wise to perform your own financial analysis if you have no professional knowledge in bookkeeping.
The net income you see in the Profit & Loss is not available cash that you could readily use in your operations. That’s important to know.
Let's say it again and let it sink in: net income you see in the Profit & Loss is not 100% available cash.
The same applies to the cash that you see in your Balance Sheet, it is not the 100% of profit that is reflected in your P & L. The P & L is your window to the financial results of your business. It shows how much you earn at a particular period. It could be presented on a monthly, quarterly, or yearly basis.
It shows you the total sales you have generated over a particular period and the corresponding expenses you incurred in generating the sales and in operating your business. Sometimes you’ll encounter the word “margin” such as gross margin and net margin. It means income or profit, too.
The formula to compute the net income of your business is —
Remember: Net Income is not outright cash.
When you see net income, it means your business is growing and showing favorable financial results. But it doesn’t mean that having a net income, your business also has available cash. Because your cash is related to other transactions your business had. It is tied up to total receivable, which you can see the balance on the Balance Sheet as of a given period. Your cash is tied-up also to the amount of inventory you have on hand.
Let’s explain further why your income is tied-up to your accounts receivable.
If you sell your products to your customers on credit, the sale you made is recorded as sale on the month the sale occurred. The following is the journal entry:
With the above entry, you don’t realize cash as you made your sale but it is already recorded as sale that increased your gross profit. You’ll only record cash when the customer pays you, which could be after 15 days, 30 days, 60 days or 90 days depending on your agreement.
When your customer pays you for the services or goods he got on account, below is the journal entry to be made:
If the payment is after the sale, you will notice that no income was recognized. It was because income was already recognized during the period the sale was made. (See the first sample journal entry) This is a simple explanation why your reported profit as of a particular period does not translate to cash you may have on hand.
To enable you to fully understand what your profit and loss statement is showing you and why the net profit is not available cash that you could use immediately for business operations, you also need to understand the cash flow statement.
A cash flow statement shows the inflow and outflow of cash to and from your business. The inflow occurs from the sale of your merchandise or services. It could also come from the sale of other assets like old or unused properties, proceeds from loan, cash dividends received from stock investments or additional capital by a business partner. On the other hand, cash outflows represent disbursements made for purchases of inventories, supplies or equipment, payment of loans or credit, or investments.
A positive cash flow statement signifies that your business could pay recurring expenses each month. Managing your available cash could help you decide to invest the extra cash as you see fit.
Knowing the relation of profit and loss and cash flow, you should not be surprised and get excited seeing a big amount of cash on your balance sheet.
This is important: Get help from your financial advisor to prepare regular cash flow statement.
Having a regular cash flow statement would help you monitor the amount of cash you will need in order to pay future expenses. It is a must that you ask your financial advisor or bookkeeper to provide you periodic cash flow statements.
This way you will identify the trend when your business is lean, or when your business rakes in the cash. In this manner, you can schedule cash disbursements for irregular payments and purchases and allot enough money for recurring expenses.
A balance sheet shows your financial position as of a given period. It is prepared at the end of the bookkeeping cycle. That is why you will see a balance sheet being captioned as Year-to-Date ending Dec 31, 2016. The reflected values in each of the accounts are as of the closing date of the bookkeeping period. The bookkeeping cycle could be a calendar year January to December or a fiscal year.
The bookkeeping formula for balance sheet is:
Assets = Liabilities + Capital or Stockholders Equity
In this formula, you can relate why receipt of loan proceeds is part of the cash inflow as well as additional capital received from business owners. Loan proceeds and additional capital are recorded as assets for cash received and at the same time the corresponding liability and capital accounts are credited. This completes the equation.
Hence, the total amount of cash reflected in your balance sheet does not represent the net income of your business.
Most small business owners don't know their numbers, and that is not a good business practice. If you don't know your numbers, you have no way of knowing the financial condition and the financial results of your business. Running your business blind will get you far from achieving your business goals. Worst, surprise! surprise! You will suddenly close shop before you even know it.
The expert advice from our FAS Managing Partner, Cristy Fontanilla would be to watch your income statement and look at your equity figures. Increasing equity means your profit is increasing and that’s a positive indicator of a growing business. But if your equity is decreasing, you have some serious problems that require your immediate attention. Watch Cristy at the Score event as she explains profit and loss for small businesses and how you can find out if your business is profitably growing.
We also prepared a presentation for you that you can download for free on SlideShare.
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