What the Hell Does This Mean?
No one will care more about your business than you.
The moment you decided to turn your passion or hobby into a business is when you took on the responsibility to learn the financial basics. This is not meant to be preachy but rather acknowledge that while you can get a bookkeeper (recommended) and an accountant and delegate many of the related functions to these pros; the accountability to be able to understand the basics of your financial statements always remains with the person who cares most about your business: You.
The Accounting industry (much like the Legal industry) has done a phenomenal job at encrypting their language leaving many business owners saying “what the hell does this mean?” Perhaps it’s to hang onto a power position or justify their hourly rates; whatever the reason, some simple demystification is in order.
Let’s look at some definitions; no need to hyperventilate and run for a double espresso; we’ll keep this green tea friendly:
Income Statement and Balance Sheet: Accounting’s dynamic duo.
An Income Statement is that piece of paper many of us look at to see if we made any money last year. Simply put, it is a statement of business activity for a period of time. It could be a day, month, or year. The main players in order of appearance are Revenue, Variable Costs, Gross Profit, Fixed Expenses, and Net Income.
A Balance Sheet is perhaps less tangible or friendly but not to be ignored. It is a statement of your business value made up of assets, liabilities and equity at a specific point in time, usually the end of the month or year. As implied by the name is always balances: Assets – Liabilities = Equity meaning that your asset value less what you owe equals your business value.
Let’s take a quick tangent to clear up another frustrating part of financial lingo. That is how different terms essentially mean the same thing. Sales and Revenue are the same. Income, Profit and Margin are all interchangeable terms. Fixed expenses are often referred to as Overhead or General and Administrative Expenses (G&A). So, Net Income, Net Profit and Net Margin are all the same thing.
INCOME STATEMENT DEFINED
The What: You’re paid $2000 for a design project. Revenue is the cash paid in exchange for awesome work. Deposits are not actually considered revenue until you perform the work but that’s a technicality.
What About It: More revenue doesn’t mean more money in your pockets or a healthier business. It’s a great start but reaching your business utopia largely depends on how you set up the rest of business. Read on.
The What: You are swamped with other work and you decide to subcontract out part of this project to Clyde who charges $500 for his part. Costs that move in correlation to your revenue are your variable costs.
What About It: As you get busier, you may use subcontractors to perform some of the ballooning workload. As the workload shrinks, the use of subcontractors also shrinks. In other words, it is variable and somewhat proportional to your revenue.
The What: After paying Clyde, you have $1500, the gross profit: Revenue less variable costs.
What About It: Why “Gross”? Who knows but gross profit is the amount of cash left to pay for your fixed expenses.
Gross Profit %:
The What: Gross profit (aka: gross margin) is often expressed as a percentage of revenue.
What About It: In this case, your Gross Profit % would be $1500/$2000 or 75%. For every $1 of revenue, your business retains 75% to pay for the remaining expenses needed to run the business.
Fixed Expenses (Overhead):
The What: We refer to these expense as fixed because you have to pay them regardless of how much revenue you earn. Your rent, utilities, and typically the largest: employee wages.
What About It: These fixed expenses come at you every month without considering how much you billed in project work, let alone collected. Having a fixed cost structure able to weather the ebbs and flows of your business will not only let you sleep at a night, but also help you make sane strategic decisions.
The income statement is laying out the detail related to your earnings over a period of time. The net income or loss ends up flowing the below balance sheet – as both cash and equity.
BALANCE SHEET DEFINED
The What: The Assets are relatively straightforward: your cash, cash owed to you from your customers (accounts receivable), any equipment and even such things as a patent. Current Assets are those such as your bank balance or accounts receivable that can be converted to cash quickly – in less than a year. Fixed Assets are physical properties of the business such as equipment, office furniture, or other investments into your office space.
What About It: Assets are meant to indicate value owned by your business at any specific point in time.
The What: Working capital is a fancy term for your bank balance.
What About It: Beyond just a bank balance figure it is intended to indicate the amount of cash you need in the bank to manage the ebbs and flows of your operations.
The What: Liabilities are what you owe: money to your suppliers (accounts payable), loans and credit card balances as examples. Current liabilities are those that must be paid in the short term – 1 year or less. Long term liabilities are just that – those that extend beyond one year such as bank loans.
What About It: Liabilities when compared to assets can indicate the health of your business. Cash and accounts receivable that’s available to pay your current liabilities would indicate your ability to pay suppliers as an example.
The What: Equity can be harder to grapple but it is effectively your business value at any point in time.
What About It: Each year the net income or loss in the business will add up in the equity section of the balance sheet. If is considered the cumulative rolling value of the company since the beginning. Net income earned will increase the equity and a loss would decrease it. As well, if you take dividends, the equity will decrease. Taking dividends is considered cashing in on the value of the company.
This bit of info should help demystify some of the finance/accounting industry lingo out there but it’s far from exhaustive. While there are many excellent financial professionals (and perhaps many more who are less so); please remember that no one will care more about your business than you. If you really want to reach your business utopia, part of the journey will require a commitment to understanding your financial statements. And once you start breaking down some of these barriers, you’ll find yourself asking the right questions and analyzing your business from different perspectives and that is all part of making better decisions.