Entrepreneurial Finance: The Function of Financial Statements

Money is the bottom line. We start, grow and invest in businesses for money. All the pains, highs and lows of business ownership are to provide for the business owner’s family, lifestyle, employees and so forth. Money allows entrepreneurs to open their business, and it is the key component to keeping the business open. While we may master our inventories, be the best at the services we offer or are brilliant at research and innovation, each business needs money to survive.

Despite the simple objective to make money in business, it is very common amongst entrepreneurs and business owners to overlook their abilities to manage the business finances. Many business owners will engage a bookkeeper or an accountant to set-up and manage the books. Others will buy financial accounting software programs and do their best to understand the power behind those types of software. However, a solid understanding of the business financial statements is critical for all business leaders regardless of how the reports are generated.

The good news is that regardless of the legal structure, type of business or size of business, the same basic financial statements apply. The financial statements are to serve as a mechanism of internal fiscal control, a tool to attract investors, a snapshot into the fiscal health of the company, a way to capture fraud before the business suffers major losses and a means to evaluate the overall functions of the business.

The first financial statement that a business needs to regularly generate is the income statement (also known as the profit and loss statement). Most businesses will want to generate this report on a monthly basis and compare the information with the previous months or to the same month from the previous year or two. If the business hasn’t opened yet, then the entrepreneur will want to generate an income statement for the first twelve months based on projected numbers they think the business will achieve. These projections need to be realistic and will be based off the market research completed during the business planning process.

The first section of the income statement will review the reporting time period’s gross revenues or how much money the business made during that time. Business owners need to include the total dollar amount of the returns and allowances the business gave in that time. The net revenue is found through subtracting the gross revenues from the returns. This is how much money the business made in the given reporting period.

The next section looks at the cost of goods sold. The business should list each major line item that contributes to how much the business pays for the products being sold. For instance, a manufacturer of widgets would track the costs of raw materials, and a retailer may wish to track the direct costs of inventory. Service oriented agencies can total the cost of delivering the service or they may opt to track overhead expenses in the next section.

The third section on the income statement tracks the operating expenses of the business (also known as overhead). Here the business should track salary expenses, which should include salary, payroll tax and any fringe benefits that the company will pay. This section should also include; rent or mortgage expenses, property taxes, sales taxes, depreciation expenses, utilities expenses, advertising expenses, insurance expenses, and any regular expenses incurred by the business.

The last section of the income statement will look at other expenses the business has on a regular basis. Typically, this is where loan interest is noted. While the business owner writes one check to pay off a loan or debt, the principal and interest are traced separately on the financial statements.

To finish the income statement, take the net revenue from section one and subtract that from the total cost of goods sold, operating expenses and other expenses. The resulting number will be your profit or loss for the reporting period.

The second financial statement is the balance sheet. The balance sheet lists all the assets and liabilities for the company. In simplest terms, this is a snapshot of the financial health of the company. A healthy business will show a well rounded balance of assets to liabilities.

On the balance sheet, current assets should be listed first. Current assets includes how much the business has in the bank, accounts receivable, inventory or any other account the business has money available in. Additionally, the business should also list all fixed assets it has. Under the fixed assets section, the business should list the value of all the land that it owns, the value of the building (if owned), value of any cars or major pieces of property owned by the business. The fixed assets should also note the cost of depreciation for any property owned by the business as well. The total fixed assets will be the value of the assets minus the depreciation.

Next, the balance sheet will list all current liabilities. Current liabilities include accounts payable, notes payable (credits, etc.) and taxes payable. Additionally, the balance sheet will list long term liabilities, which include building mortgage payable, equipment loan payable or other large debts owed by the business. Lastly, the owner’s equity will have its own line item on the balance sheet.

The magic of the balance sheet is the total assets added together, should equal the total number of liabilities plus owners equity added together. If the two numbers do not match, then a problem exists in the business or in the preparation of the balance sheet.

Whether the business owner hires help to establish and maintain the financial statements and books or whether they seek to maintain this information on their own, it is important to understand how the numbers work and what the numbers mean. Watching the business financial statements will help guide the business along in its progress, prevent fraud, alert the owner to business trends and show the business owner how the business is working for him or her.