Let your financial statements guide you to optimal business decisions

Financial Statements: A Guide to Optimal Business Decisions

Now that 2022 is up and running, business owners can expect to face a few challenges and tough choices as the year rolls along. But, no matter how busy things get, don’t forget about an easily accessible and highly informative resource that’s probably just a few clicks away: your financial statements. Each one contains different, but equally important information about your company’s financial performance. Together, they can help you and your leadership team make optimal business decisions.

Financial statements to guide optimal business decisions

Assuming you follow U.S. Generally Accepted Accounting Principles (GAAP) or similar reporting standards, your financial statements will comprise three major components: 

  1. Income statement
  2. Balance sheet
  3. Statement of cash flows

Revenue and expenses

The first component of your financial statements is the income statement. It shows revenue and expenses over a given accounting period. A commonly used term when discussing income statements is “net income.” The net income is the income remaining after you’ve paid all expenses, including taxes.

It’s also essential to check out “gross profit.” The gross profit is the income earned after subtracting the cost of goods sold from revenue. The cost of goods sold includes the cost of direct labor, materials, and any manufacturing overhead costs required to make a product.

The income statement also lists sales, general and administrative (SG&A) expenses. They reflect functions, such as marketing and payroll, that support a company’s products or services. Often, SG&A costs are relatively fixed, no matter how well your business is doing. Calculate the SG&A costs to revenue ratio: If the percentage increases over time, the business may be slowing down.

Assets, liabilities, and net worth

The second component is the balance sheet. It tallies your assets, liabilities, and net worth to create a snapshot of the company’s financial health on the financial statement date. You list assets in order of liquidity. Current assets (such as accounts receivable) should convert into cash within a year. Long-term assets (such as plant and equipment) aim to generate revenue beyond the next 12 months.

Similarly, you list liabilities in order of maturity. Current liabilities (such as accounts payable) come due within a year. Long-term liabilities are payment obligations that extend beyond the current year.

True to its name, the balance sheet must balance — that is, assets must equal liabilities plus net worth. So, net worth is the extent to which assets exceed liabilities. It may signal financial distress if your net worth is negative.

Other red flags include current assets that grow faster than sales and a deteriorating ratio of current assets to current liabilities. These trends could indicate that management is managing working capital less efficiently than in previous periods.

Inflows and outflows of cash

The statement of cash flows shows all cash flowing in and out of your business during the accounting period.

Cash inflows typically come from selling products or services, borrowing, and selling stock. Outflows generally result from paying expenses, investing in capital equipment, and repaying debt. The statement of cash flows has three sections; cash flows from activities related to:

  1. Operating
  2. Financing
  3. Investing

Ideally, a company will generate enough cash from operations to cover its expenses. If not, it might need to borrow money or sell stock to survive.

Making optimal business decisions

Sometimes business owners get into the habit of thinking of their financial statements as a regularly occurring formality performed to satisfy outside parties such as investors and lenders. On the contrary, your financial statements contain a wealth of data that can allow you to calculate ratios and identify trends — both good and bad — affecting the business. For help generating accurate financial statements and analyzing the information therein,contact our RRBB accountants and advisors.

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