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Financial Fundamentals

The three key parts of the financial picture that every business owner should know about their company
April 10, 2006
URL: http://www.entrepreneur.com/article/159786

Business owners rarely go into business to deal with the financial aspects of running a company. And it's easy to understand why: You're most likely passionate about the products or services you provide and want to focus your time and energy there. So your financial responsibilities usually fall to the bottom of your "desirable duties" list.

But it's critical to the long-term success of your business that you understand some of the financial fundamentals of being a business owner. You don't have to be an accountant or a financial analyst, but it's important that you have some key skills in your business toolkit to measure the financial aspects of your business.

And while it's okay to outsource this activity so that someone else can do the work you don't like to do, you need to be sure you understand the output of the financial information. You'll need it to help make informed decisions about your business. Remember: Accounting isn't just about taxes. There's so much more to know about the numbers, so you'll know how your business is doing from a management perspective.

There are a number of key parts of the financial picture that you need to be aware of, and they can be outlined based on the three critical financial statements your business generates: profit/loss, cash flow and balance sheet.

I meet with entrepreneurs every day who are unsure of their business's profitability. They "think" they're making money because they have money in their checking account. But this is not how you should be running your business!

Having money in your checking account doesn't mean you're profitable. It could mean you haven't paid all your bills so you still have a little cash on hand. But cash and profit are two different concepts. If you aren't profitable, you won't have long-term success in your business.

So what's the difference between profit and cash? Profits are determined through the following equation:

Revenues - Cost of Goods Sold = Gross Profit - Overhead Expenses = Net Profit

This equation is equivalent of your profit/loss statement. Revenues are the dollars that come from generating sales within your business. The cost of goods sold reflects the direct costs of labor and materials involved in your business. Overhead expenses encompass all those other costs that you incur so that your business can function, such as rent, taxes, insurance, marketing and accounting.

You can have activities that affect your cash but aren't considered revenues or expenses. For example, when you borrow money from a lender, that money is not considered income. It's classified as an increase in your liabilities (that is, your debt). When you repay that loan, it won't be considered an expense--it's a reduction in your liability. Any interest you might incur on that loan would be classified as interest expense, but the principal portion is not. Similar concepts apply for owner investments and withdrawals.

Often, small-business owners don't clearly understand the concepts of cash and profit and therefore don't have a good handle on their finances and how to interpret any outcomes from financial reporting. For instance, did you know that you can show a profit and still have a negative cash flow? You can, if your loan payments, owner withdrawals and other non-expense activities are taking more cash out of your business than you have profit.

The same is true on the opposite side of the flow: You can have a lot of cash coming into your business through an increase in personal or lender-financed activities and still not show a profit (because you're not generating enough revenue). The most basic cash flow statement can be outlined as follows:

Beginning Cash Balance + Cash Inflows - Cash Outflows = Ending Cash Balance

It's important for you to understand the difference between your profit/loss statement and your cash flow statement. They provide two very different views of your business.

The third financial statement you should be generating monthly is the balance sheet. The balance sheet provides information on your assets, liabilities and equity. Assets are what you own that is of value, such as your bank accounts, accounts receivable, inventory, property, manufacturing facility and equipment.

Liabilities represent your obligations to others and include such things as accounts payable, notes payable to lenders and loans from shareholders. The equity balance reflects the value of your ownership in your business. When you take the value of your assets less the value of your liabilities, the remainder is your equity.

It doesn't matter the size of your business--profitability and ongoing financial stability are something you should be monitoring on a regular monthly basis. And while some entrepreneurs will say their business is too small to have to create financial statements for it, that's just a way of not holding yourself accountable for managing your business wisely. It'll always be someone else's fault when your business fails...or at least that's what you'll say.

You can choose to succeed, or you can choose to fail. It's always a choice, not a default. So make the choice to be a financially informed business owner. Your business will thank you through its increased profitability and longevity!