Financial statements are more than just numbers on a page. Your statement tells a story that helps you better understand how your company is performing and gives you the tools to make smarter decisions to reach your goals.
Your statements will help your business answer important questions, like:
- Are we financially healthy? Revenue may come in each month and even be higher each quarter, but higher revenue doesn’t always translate to greater profits.
- Where is the business headed? Your statements will tell you a story of your cash and debt as well as your overall health equity.
- Where should we invest or scale back? Investments may pan out, or they may fall short. Your financial statements will help you better understand where investing makes the most sense and which areas are becoming less profitable.
Before you can answer all of these questions, you’ll need to read your statements properly, starting with the balance sheet.
Use Your Balance Sheet to Understand Your Financial Position
Balance sheets look intimidating at first. You see all of these numbers, red flags, and even debt-to-equity ratios that banks look at to know if your business is worth the risk of investing in.
Your key focus in your balance sheet is:
- Cash
- Debt
- Owner’s equity
- Receivables and inventory
- Liabilities
Lending requires your debt-to-equity (“D/E”) ratio to be low, especially during times of economic uncertainty. Banks prefer your D/E to be under 2:1 – even 1.5:1 – in today’s economic landscape, which means it will be much easier to borrow.
Banks have gotten more conservative in their willingness to take on risk, and there was a time when even a 3:1 D/E ratio was ok.
Reducing your D/E to 1.5:1 makes it easier for your business to expand, purchase new equipment and assets and replace things, such as trucks. Companies should strive for healthy equity to secure financing to help them grow.
Why?
A D/E of 1.5:1, or as close as you can get it, makes your company more attractive to investors and banks. High debt and low equity is a red flag for lenders and makes it harder to borrow money.
Maintaining low debt-to-equity also means you’re not stretching your finances too thin.
Next it’s time to turn to the income statement, which is what helps you reach your profitability goals.
Use Your Income Statement to Track Profitability
Every business aims to be profitable. Are you on track to reach your profitability goals? Your income statement can help you answer that question.
First, let’s break down how to measure profitability using the data from your income statement.
You’ll need two key components:
- Gross profit, which is your revenue minus your direct costs (cost of goods sold)
- Overhead, which includes your fixed costs like rent and insurance
With these two pieces of data, you can calculate your net operating profit:
- Net operating profit = Gross profit – Overhead
With this figure in mind, you can start analyzing your income statement and asking yourself a few important questions:
- Are your gross margins consistent, or are they increasing or decreasing? Why? For example, maybe margins dropped, but you’re in a growth phase so volume and profit are up.
- Are you spending effectively on sales and marketing? If you’re investing a lot into marketing but your sales aren’t budging, this is a problem.
- How do your margins and outcomes compare to your budget? Look at profit and loss with your budget.
- How do your margins compare to your industry standards?
If your business isn’t performing well, now may not be the time to take large draws. But if things are going well, don’t feel guilty about rewarding yourself.
Use Your Statement of Cash Flows to Improve the Financial Performance of Your Business
Your statement of cash flow can give you valuable insights into your business’s financial performance and how you can improve it.
Start with your operating cash flow. Are you in the positive zone? If so, is this figure higher than profit?
Negative operating cash flow is a red flag. It means your business isn’t generating enough cash to cover its operating expenses.
If you’re in the red or your cash flow isn’t as high as you want it to be, ask yourself:
- Are we collecting on invoices fast enough?
- Are we prepaying too many expenses?
- Are we spending too much overall and is there room for negotiations with vendors to lower prices?
- Are we continuing to borrow even though we’re not growing?
Healthy cash flow is what funds reinvestment in your business and helps you repay debt. If you’re not hitting your targets, use the data on your statement to make informed decisions on where to cut expenses and make changes to your collections processes to improve your future cash flow.
Use KPIs to Measure Your Progress
Now that you know how to use your financial statements to make better business decisions, let’s dive a little deeper to look at the KPIs you should be tracking.
These KPIs (key performance indicators) are metrics you can use to measure your progress and better assess your financial statements.
You don’t need to track every KPI. Just focus on the ones that are the most impactful, such as:
- Inventory turnover to gauge whether you’re managing your inventory efficiently. If your current process is inefficient, what steps can you take to change that?
- Days in receivables to measure how quickly you’re getting paid. If you’re not getting paid fast enough, how can you change your processes to reduce this period?
- Sales volume to analyze your overall performance. If you’re not meeting your sales targets, what can you do to change that (adjust your marketing, change your positioning, etc.)?
- Gross profit percentage to see if you’re hitting your target margins. If you’re off course, how can you adjust things to hit those margins (reduce costs, increase your pricing, etc.)?
- Productivity measurements specific to your industry such as units produced, downtime, rework, deadlines missed, etc.
Final Thoughts
Your financial statements tell a story. They help you understand how your business is performing today and how it performed in the past. But they can do so much more than just help you look back. They can also help you plan ahead and make informed decisions backed by solid data.
Use them to gauge whether you’re on track to reaching your goals and what steps you can take to correct the course if needed.
By taking this approach, you will be well on your way to running a healthier and more resilient business.
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