Managing the finances of a small business is a multi-layered task. You need to become familiar with standard financial documents, pay attention to profits, and make the most of the business’s assets. And you always have to be thinking and planning ahead. You have some work to do, get to it!
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Important Financial Documents for Your Small Business
Managing the finances of your small business can be a challenge. To survive and thrive, you must earn profit consistently, generate cash flow from profit, and control your financial condition. You need a separate financial statement to highlight each aspect:
The P&L Statement (also called the Income, or Earnings Statement) summarizes revenue and expenses and reports your resulting profit or loss — that’s what the P and L stand for.
The Statement of Cash Flows begins by reporting the net increase or decrease in cash from your revenue and expenses during the period (which is a different amount than your profit or loss for the period); this statement also summarizes other sources of cash you tapped during the period, and what you did with your available cash.
The Balance Sheet (also called the Statement of Financial Condition) summarizes your assets and liabilities at the close of business on the last day of the profit period and reports the sources of your owners’ equity (assets less liabilities).
Make sure that you know how to read and interpret your financial statements. Not understanding your own business’s financial statements puts you at a serious disadvantage in making good business decisions and in dealing with your lenders and owners.
Of course, the information in your financial statements is no better than your accounting system. Hire a competent accountant to design and run your accounting system. Your accountant can be a valuable helpmate in managing your financial affairs.
Don’t confuse your balance sheet with the market value of your business. True, your balance sheet reports your assets and liabilities, and the difference equals the book value of your owners’ equity. Keep in mind, however, that historical costs are the values for many assets, and the balance sheet does not report your profit performance over recent years. Yet, the market value of a business depends heavily on current replacement values of your assets and your recent profit performance.
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Paying Attention to Profit in Your Small Business
Your small business is designed to make a profit — even if you’re not making one yet. Managing the financial aspects of profit requires special skills and powers of recognition. The following list offers tips on what to pay attention to:
Cash flow accounting doesn’t tell you profit for the period, and accrual-basis profit accounting doesn’t tell you cash flow for the period. Credit sales are recorded as revenue before cash is received. Some expenses are recorded before cash is paid, and some are recorded after cash is spent. Depreciation expense is not a cash outlay in the period. Never confuse profit and cash flow. You need to look at your P&L report for your profit, and you need to look at your Statement of Cash Flows for your cash flow.
Read the preceding tip again! Deep down in your psyche you probably believe that profit equals cash flow. You may want to believe this, but it ain’t so. Make certain that you have a firm grip on what cash flow is — and isn’t.
Use a compact profit model for decision-making analysis. The P&L report is indispensable for controlling profit performance, but this profit performance report is too bulky for decision-making analysis. A compact profit model is better. The P&L statement is like a high-end digital SLR camera; a profit model is like a pocket-size digital camera that you carry around with you and is good enough for most uses.
Seemingly small changes in profit factors can cause staggering differences. A small slippage in the ratio of margin on sales revenue can have a devastating impact on profit. A slight boost in sales price or a relatively modest increase in sales volume can yield a remarkable gain in profit. Small changes mean a lot.
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How to Make the Most of Your Small Business’s Assets
The assets of your small business drive your financial picture to a large extent, so you need to know how to manage those assets to maximize their use to you. Use the tips in the following list to help put your assets to work for your business:
Determine the sizes of assets you need to support the level of your annual sales revenue. The amount of your total assets determines the amount of capital you have to raise, and capital has a cost. The more assets you have, the more capital you need. Downsize your assets as long as you don’t hurt sales.
Don’t rush into securing debt and equity capital without doing due diligence. Many small businesses are desperate for capital. Carefully examine the true, total cost of the capital and scrutinize the potential for interference from capital sources in running your business.
Businesses that make profit generate taxable income. Small business (“S”) corporations, partnerships, and LLCs (limited liability companies) don’t have to pay income tax. They are pass-through tax entities; so, their owners include their respective shares of the business’s taxable income in their individual income tax returns. The profit of a pass-through business is taxed only once — in the hands of its owners. Cash dividends paid to stockholders by regular (“C”) corporations from their after-tax profits are included in the individual income tax returns of their stockholders and are thus subject to a second tax in the hands of the stockholders.
To keep your assets working for your business, trust, but protect. Business is done on the basis of mutual trust, but not everyone is trustworthy, even a longtime employee and a close relative. Enforce effective controls to minimize threats of theft and fraud against your business. An ounce of prevention is worth a pound of cure.
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How to Plan Ahead for Your Small Business
As the owner or manager of a small business, of course you’re very busy, but it pays to step back and plan for your financial future. Take the time to forecast, plan, and budget. Have your Controller (chief accountant) prepare the following pro forma (according to plan) financial statements:
Budgeted P&L statement for the coming year. Even if this budgeted P&L is abbreviated and condensed, it plays an invaluable role. Provide your Controller your best estimates and forecasts for sales prices, costs, and sales volume during the coming year. From this information your accountant can prepare a P&L that serves as your performance benchmark as you go through the year. Don’t be afraid to change the budgeted P&L in midstream. Sometimes totally unpredictable events make your original P&L budget out of date.
Budgeted Balance Sheet at end of coming year. You don’t necessarily need a detailed listing of every asset and liability one year off. But you definitely should look ahead to your general, overall financial condition one year later. It’s better to spot problems earlier than later. Looking down the road at where your financial condition is heading can help you avoid major problems.
Budgeted Statement of Cash Flows. Preparing this budgeted financial statement is an excellent way to keep close tabs on your cash flow from profit (operating activities) and how you plan to use this cash flow. If you are planning major capital expenditures (new investments to replace, modernize, and expand your long-term operating asserts) a budgeted statement of cash flows is essential for making strategic decisions regarding how you will secure the cash for these expenditures.
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