Let’s say your business is starting to rake in some serious cash - congrats, friend! Now that your business is becoming more profitable, you will need to put in some work to stay on top of your bookkeeping - or, hire a bookkeeper instead! Regardless of whether you take on your bookkeeping in house or work with a qualified professional to keep watch over your books, you’ll want to be sure you have a clear understanding of how your Income Statement and Balance Sheet can be used to make better decisions for your business.
Understanding these key financial statements will help you take a proactive approach to your business finances. Using historical financial data, you can analyze your past performance to drive smart business decisions in the future, project the long term growth of your business, explain your value to investors, and more.
Now, you might be asking yourself “How can my Income Statement and Balance Sheet help me make better business decisions?” We’re glad you asked!
Let’s go through the key elements of your Income Statement and Balance Sheet together.
Understanding your Income Statement
Your Income Statement - commonly known as the Profit and Loss or P&L Statement - is a report that shows your business’s revenue and expenses over a defined period of time. While this report seems pretty straightforward, we encourage you to avoid taking it at face value. Here’s why.
The Income Statement shows only you the money coming in through sales and the money going out through overhead expenses and direct cost (sometimes referred to as Cost of Goods Sold, COGS). It does NOT include any money received from loans, principal paid on loans (though, interest paid would be included), fixed asset purchases, accumulated depreciation on assets, or other items that would show up on your Balance Sheet.
The primary purpose of the Income Statement is to show you business profitability and expenditure. Plus, you can utilize a lot of the data to predict future cash flow, create KPIs, determine budgets, and evaluate cash flow health.
The relationship between the Income Statement and Balance Sheet is one of the hardest concepts for business owners to understand. Luckily, we’re going to clear things up for you so that you can start leveraging this financial data to your advantage!
Understanding your Balance Sheet
Now that you understand the strengths and weaknesses of the Income Statement, let’s define what’s in your Balance Sheet. This key financial statement can be divided into three main categories: assets, liabilities, and equity. Here’s the difference between these categories in the simplest terms:
Assets are what your business owns or things that add value to the company. Generally, assets are considered equipment or some intangible items that cost over $2,500. However, every company adopts a different standard for how to determine what is an asset. The important thing is that once you establish a standard for your business, you will need to stick with it!
Liabilities are what your business owes. This includes loans, lines of credit, credit card debts, and any other accounts that are recallable within a year.
Equity is everything else, including shareholders equity. This is often referred to as capital or net worth. If you sold off all your assets and paid your liabilities, equity would be the amount paid to or received from all of your business’s owners and shareholders.
How to leverage your Income Statement and Balance Sheet together
Now that you understand the information contained in the Income Statement and the Balance Sheet, let’s go over an example to show you how to categorize different types of items on the appropriate reports.
Let’s say that you run a cleaning business, and your clients pay your business directly. Each month, you purchase different types of cleaning supplies and pay salaries to each of your team members. As your business grows, you purchase a van to transport your equipment using a loan. Each month, you pay principal and interest on the loan for your van as well as liability insurance. In this scenario, your purchases would be broken down between financial statements like this:
You might be asking, why don’t these all go in the same report? Accounting experts have determined that putting these two categories together can significantly muddy the waters and make it difficult for business owners to understand the financials of their business.
When separate, you can use this financial data in some pretty powerful ways. Here are some ways to think about the two and use them to your advantage:
The Income Statement does a great job of showing your monthly, quarterly, or yearly profits or losses. Because of this, The Income Statement shows you historical trends from an operational perspective and gives you valuable insights to make good business decisions. For example, you might notice that revenue typically goes up in specific months, or you can use this data to check your Return on Investment or ROI on certain marketing expenses.
The Balance Sheet, on the other hand, shows you more about the value of your business. To put it simply, an investor would not want to buy equity in your business based on your Income Statement because it would give them little information about high value items your company owns or the debt your business owes. You can use this report to calculate your business’ valuation or explain your financial position to potential investors or lenders.
Understanding your financial statements can help you make smarter business decisions, know when you’re ready to scale, and so much more.
Could you use a professional on your team to help you better understand these statements and use them to drive your business forward?
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