How to Read Financial Statements

By Merle T. Northrop, Flatiron Ventures, Inc.

Part 1 of 3 – The Balance Sheet

Merle Northrop

Like reading any book, start at the beginning, and I believe the beginning of financial statements is the Balance Sheet. A straightforward analogy is to look at the Balance Sheet as a still photo of everything your business “Owns” and “Owes,” and what’s leftover is your “Equity” at a point in time. A Profit and Loss Statement is similar to a motion picture, showing the movements of money through your business from one Balance Sheet to the next in a chain link fashion.

A very important consideration in your Financial Statements is whether they are based on a “Cash Basis” or “Accrual” method. “Cash” means when money comes in, it’s income and when your checks are mailed, it’s expensed. Accrual” means when “Title” to the item changes from you or to you, it then represents the date of the action. Generally, “Accrual” is more accurate representation of your business but somewhat more difficult to keep accurately. But whatever method you’ve been using, keep the same unless you have a conversation with you accountant on the ramifications of changing.

So, with the Balance Sheet, I like to develop relationships between line items and something else. For instance, Accounts Receivable (A/R) compared to average monthly Revenue. If the A/R is equal to one-month’s revenue, you have 12 turns of that money a year. Generally, with cash-based businesses, like retail, this turnover should be a higher number of turns. Unfortunately, in many businesses, Receivables are a place where money gets forgotten and ultimately lost. So be sure you’re reviewing outstanding A/R’s weekly and following up with customers who fall outside your normal terms.

The same analysis takes place with Accounts Payable (A/P) compared to a combination of costs of products and maybe contract labor. Here it’s best if the turnover rate is very high, meaning the amount of money you owe others is fairly low. If your vendors are paid promptly, you might have discounts available that should be taken, and the vendors are likely incredibly happy doing business with you.

Inventory is a bit more complicated, depending on how the business conducts a physical inventory and when it’s done. The difficulty is that you might have an abundance of low-cost items, more than you will use in a reasonable time period, or you might have a few high-priced items that take a long time to obtain, and your actual inventory is low, but the dollar amount it represents is high. So, with inventory, it’s best to segregate in your accounting system so you can look at the individual groups and make a buy or no-buy decision accordingly. Very rarely does inventory increase in value with age, except maybe wine and trees (for a while!).

For reviewing Fixed Assets, again, I like to segregate fixed assets into different line items somewhat based on the life expectancy of a group of assets. For instance, electronics have a 3–5-year usefulness life whereas a tractor, truck, compressor might last 15 to 20 years. Real estate should always be a separate line item. Compare what I call the “working assets” like tractors and compressors to the Revenue each item generates per year. Calculate the return on that asset group. (Assume the tractor costs $100,000 and you generate $200,000 in revenue with it, a two times turnover. Is that enough turnover when you build in labor and maintenance costs?) If you find you have excess fixed assets, try to dispose of some to convert the asset into cash to use for other higher turnover assets.

The last item I look at is Cash in the Bank! I am adamantly against what I call “Checkbook Management”!  “If I have money in the bank, I’m fine!” Maybe and maybe not. All things that happen in your business ultimately fall into the Cash account.  How much cash is needed to support normal operations?  Perhaps a good guideline is having enough cash to pay 1 or 2 months average fixed expenses including payroll. If you have high fluctuations in inventory, it might be best to obtain a Line of Credit loan for the times inventory goes up and pay it down when the inventory declines. Cash is the muscle of your business, and just like you, you don’t want to starve your body, you don’t want to drain cash to the point the business is stressed. Remember, your business is the “Goose That Laid the Golden Egg” but if you starve the Goose, you could lose the business!

Something I’ve observed over the years of reviewing financial statements with business owners is that often inappropriate things get “parked” in the Balance Sheet. It might be a charge that isn’t really an asset. Or an asset that remains on the Balance Sheet after it’s been disposed of and the proceeds may not have been recorded properly or even not received at all! I’ve encountered a fair amount of embezzlement and often the trail is through the Balance Sheet.

Merle T. Northrop

Flatiron Ventures, Inc.
1600 38th St., Suite 203
Boulder,  CO  80301 303-440-6141

Next Issue – Part 2: The Income Statement