As you may well know, numbers tell a story and there are three major financial statements, each containing different stories but all linked together that helps you see the whole story of your business through numbers. The key is to learn how to connect the dots. Let’s begin to understand how to read your financial statements.
Step 1. Note the timeframe of your income statement
Your income statements cover a certain period of time that shows you how much money you made during that period.
In the income statement, you will find sections that read year-to-date reflecting your business activities from a certain period up to the current date. If you see “Y-T-D December,” this indicates the period from January 1 until December 31.
Why is the time in your income statement important? Well, you get to take a look at how your business performed over a month or a quarter or a year. When you begin to understand how your business is performing during a period of time, you can forecast your performance for the next period and set your targets based on your current performance data.
Step 2. Follow the simple formula
No matter how complex financial reports may seem, it’s important that you know the simple formula you should follow to see if your business is earning profit. That is, revenue - expenses = profit.
Keep in mind, it is that simple. Determine how much revenue your business made, how much expenses your business incurred, and you will see how much profit you made.
Why do you have to care about the formula? The formula helps you determine if your business is still earning to keep it alive or returning negative numbers and soon to be kicked out of the game that means declaring bankruptcy for you.
Step 3. Embrace the jargon
It often gets overwhelming to learn all the terms used. But don’t get lost. They are just names referring to one thing. For example, “sales” and “income” and “revenue” all mean the same thing.
The important thing to remember here is to understand that money you receive (income) less the money you spend (expenses) equals the money you get to keep (profit or revenue). Regardless of the term used, go back to the basic formula.
Step 4. Look at your gross margin percent
Your gross margin reflects your business growth or sluggish performance. This data gives you the ability to identify when your costs are skyrocketing high and outpacing your revenue gains. This piece of information also signals for you to take immediate action in case your numbers are showing red flags.
But first, understand that your expenses are split into parts and the calculation of your profit is at interim levels.
What does it mean? When you see this list: revenue, cost of goods sold, gross margin, selling, general and administrative, profit - it shows your expenses split into two parts: cost of goods sold (COGS) and selling, general and administrative (SG&A).
What are COGS and SG&A? COGS are direct costs for the products or services you sold, which includes materials and other expenses incurred to build the product or services. In general, this cost vary directly with revenue. SG&A are indirect costs which include manpower, rent and other bills necessary to support the business. These are constant monthly costs that don’t vary with the total number of products sold.
Now that you understand there are separate types of expenses, let’s move to discuss profit. The calculation of your profit is at interim level or the gross margin. The formula is gross margin = revenue - COGS.
What is gross margin? It is the money you get from selling the products minus the cost incurred to deliver.
You should consider calculating for the gross margin as a percentage of revenue, which should show a relatively increasing figure. The value in this is to see that your COGS moves with revenue. See the formula below:
Gross margin percentage = gross margin/revenue
Your gross margin percentage should be increasing. If not, say for example one period shows your gross margin percentage dropped, it is important that you investigate what is going on.
In some cases, there are valid reasons that cause the change but under normal circumstances, your gross margin percentage should be increasing.
One additional note is to keep a tab on your SG&A expenses. Your SG&A dollar spending should be constant and any shift needs to be further examined to find out what is happening in your business to incur such change.
When you follow the steps outlined above, you soon realize that your financial statements tell you the story of your business and offers you insights that will help you make sound management decisions. Now, how do you connect the dots? Find out what each of your financial statements tell you.
What does your income statement tell you? It tells your business profitability over a period of time. It shows your total sales against your costs and if the costs are less than your sales, then it means your business is making profit.
What do you do with your profit? There are two things you can do:
Return to shareholders (dividend)
If you re-invest, it will show in your balance sheet labeled as additional amount owed to shareholders or equity.
If you look at your balance sheet, you will see your assets and liabilities for your business and identify where your funds are coming from and what you are doing with the money.
The cash flow statement reconciles the first two documents -- the profit that your business generated in the income statement (profit and loss) and the movement of the cash in the balance sheet.
For certain, your financial advisor can tell you more and it is a good business practice to have a financial checkup at least once on a yearly basis.
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