What’s the point of creating a budget if it’s not possible to follow through? — Alexa Von Tobel
It’s October which can only mean one thing for many companies: it’s budgeting time. If the thought of crunching numbers fills you with dread, it’s time to lean in and make this the year you understand financial statements and other aspects of budgeting and finance required of leadership. After all, it’s hard to spearhead a department (and certainly an organization!) if you don’t.
During Part 1: Understanding Budgets and What Makes Your Company Profitable, we walked through key financial terms, how to pull together the data, determining the ROI (return on investment) of projects and finally, bulletproofing your budget when presenting to the C-Suite. If you missed that blog, I strongly suggest you read it first because those fundamentals feed into our next topic: understanding your organizations key financial statements. Let’s take a look at each and determine what information it’s telling us.
The Three Key Financial Statements
Watch your finances like a hawk. —H. Jackson Brown Jr.
Why is learning to read financial statements important?
Because knowing how to read and interpret what the #’s are telling you could mean the very survival of your company.
Several external parties also care about your company books. Shareholders review your financials to understand how well their capital is being managed. Outside investors use financial statements to determine if they should invest in your company. Lenders and suppliers use your financials to determine your creditworthiness. Publicly traded companies are required to publish financials and make them available to anyone who wants to view them (privately held companies typically don’t make their financials available to anyone except their owners and the bank).
Let’s take a peek at three statements that play a particularly important role in your company’s business operations.
The Income Statement
Revenues, expenses, profits, the matching principal, and accrual-based accounting all have a home in the income statement, which measures whether the products or services that your company provides are profitable over a period of time (unlike the Balance Sheet which is a point in time financial measurement tool).
This tool is also known as the profit-and-loss statement or P&L. This statement shows the profitability at the end of a particular timeframe – typically at the end of each month, quarter or fiscal year. Perhaps even more importantly – this statement also details how much money the company had to spend in order to earn that profit. A simple representation of the Income Statements looks like this:
Revenues – Expenses = Net Income (or Net Loss)
Here is a sample Income Statement:
Sales (aka revenues) are shown first (note revenue comes from not only selling your products or services but also from investments or the sale of assets). Then the various costs and expenses are subtracted from those revenues. As you can see, the “bottom line” is the Net Income (or Loss) for the company.
- gross profit (total sales minus cost of goods) – this is the roughest estimation of the company’s profitability and not surprising, you want this # as high as possible since you’ll pull expenses from gross profit
- operating profit (gross profit minus operating and depreciation expenses) – operating expenses include admin employee salaries, rents, sales and marketing costs and other business costs not directly attributed to the cost of making your product. This is also called operating earnings or earnings before interest and taxes (EBIT)
- net profit or net income (operating profit minus interest and taxes, aka the “bottom line”)
- The operating profit line indicates whether the core of the business is functioning at a profit or at a loss.
- It is possible for a company to have a high gross profit (i.e., something in the rage of 25 percent to 50 percent) but have a relatively low operating profit due to costs associated with marketing the product, for example, or with managing the company.
- Think of operating profit as a measure of how efficient management is at generating revenues and controlling expenses.
The real value in income statements is realized when comparing multiple years as shown below:
We can see Bob & Tom’s annual retail sales have grown steadily while its corporate sales seem to have petered out (and even declined slightly). The good news though? Operating expenses have stayed roughly the same, meaning they have become more efficient at cranking out candy (> production with < production expense). B&T are basically holding the line in terms of the cost of doing business. They have also decreased interest expense, perhaps because they paid off a loan. Their net income over this four year period has shown healthy growth (hence why it’s important to take a multi-year snapshot of your company using data from the Income Statement).
The Balance Sheet
This statement indicates what the company owns (assets), what the company owes (liabilities), and how much the company is worth (equity) at any given point in time (NOTE: “point” in time, not “over a period” of time like the P&L). The balance sheet indicates how efficiently a company is utilizing its assets and managing its liabilities. The Balance Sheet illustrates the fundamental accounting equation (what I referred to in my previous post as the Queen Mother of All Accounting Equations):
assets = liabilities + equity
In essence, this equation illustrates how assets are financed – with funds from creditors (liabilities), with the capital of company owner’s (equity) or both.
Here is an example of a balance sheet:
I already mentioned the definition of asset (something the business owns), however, you may notice there are two assets listed:
- Current assets (also known as “short-term assets”: assets that are expected to be sold or turned into cash within one year. Examples: cash, accounts receivable, prepaid accounts such as rent or insurance.
- Long-term assets (aka “non-current assets”): assets that will take more than a year to be used up or turned into cash. Examples above include Long-Term Investments & Funds and Property, Plant & Equipment (sometimes referred to as furnishings, fixtures or equipment or FFE.
You divide into current vs. long-term assets as it’s a measure of a firm’s liquidity (i.e., how quickly can they turn assets into cash if needed).
You’ll see a similar pattern on the liabilities side of the equation:
- Current Liabilities: liabilities that are due within 12 months from the reporting period. Examples: accounts payable, taxes payable (such as payroll taxes.
- Long-term Liabilities: a debt that is due more than one year out from the date being reviewed.
Under Owners Equity, notice retained earnings. These are earnings that are reinvested in the business after the deduction of any dividends.
From the Balance Sheet, you can determine the Net Worth of a company as illustrated here:
- net worth (or book value) of the company = stockholders’ equity – preferred stock
The Statement of Cash Flows
This financial tool illustrates how the company’s cash came in and how that cash was used. Where the income statement focuses on accounting profitability, the state of cash flow is all about cash profitability: it translates the actions taken in the income statement and in the balance sheet (company purchases, sales, etc.) into cash flow. In the business world, cash is king—and this tool plays a vital role in showing exactly where a company’s money is going.
There are typically three types of cash listed on this statement:
- Operating activities
- Investing activities
- Financing activities
Similar to your monthly bank statement, the cash flow statement indicates how much cash you had on hand at the start of the period and at the end. This statement is particularly critical in times when cash is tight.
Here is an example:
The budget is not just a collection of numbers, but an expression of our values and aspirations. — Jack Lew
Do you need to be an expert on finance and budget matters? Not necessarily (well, unless you work in the finance department or are the CFO!). But all leaders should have enough financial literacy to understand how to create and manage a budget as well as how that fits into the company’s overall health. If you can’t, put this at the top of your “To do” list!
Finally, here are a couple great resources to continue your learnings on budgeting and finance:
The Essentials of Finance and Budgeting; Harvard Business School Press – this is an oldie but a goodie – the book is geared toward HR professionals, but the lessons in managing an overhead department’s budget is universal.
Financial Intelligence, Revised Edition: A Manager’s Guide to Knowing What the Numbers Really Mean; Karen Berman and Joe Knight – perhaps my favorite on the list – the authors do an outstanding job of relating the principles of finance and accounting in layman’s terms.
What outstanding questions can I answer for you?