Financial literacy is one of the most important things to understand as a business owner. The financial decisions you make as a business owner have a huge impact on your success and profitability. Making informed decisions that drive profitability requires a good working knowledge of finance and accounting. The problem is many business owners don’t know beyond the basics. It’s understandable- after all, unless you started a business in that field it’s not your area of expertise. You’ve spent your professional energy becoming an expert in something else. No one can be an expert in everything, just as Michael Jordan wasn’t the best baseball player. That being said, there are plenty of very good reasons for improving your financial literacy as an entrepreneur. In this post, we’ll take a look at what every business owner needs to know about finances and accounting and why in order to make their company profitable and sustainable.
Why Understanding Your Financial Statements Is Important
The financial statements are vital to keep a pulse of what is going on in your business’ finances. When you don’t know where things stand financially you can’t make informed decisions. When profitability declines but you aren’t aware because you don’t get accurate or timely financials, what do you do? You won’t know what action to take because you really don’t know what’s driving the problem, but really you won’t take any action because you don’t even realize the problem. What if cash flow management isn’t effective, you’re flying blind and maybe could have trouble meeting payroll. Sure you might argue that’s your CFOs job and you trust them. While true, as the business owner you make decisions that have the most significant impact, and making bad decisions can be catastrophic for your business. Making informed decisions requires not only having good data but also interpreting it.
Additionally, while you may craft the strategy for the business at a high level, your management team to execute the strategy on a day-to-day basis. Accordingly, it is important to have everyone on your management team knowledgeable to keep everyone on the same page and speaking the same financial language. This reduces miscommunication, keeps the team aligned, and allows the management team to see the bigger picture so they can implement the overall business strategy at the ground level.
The bottom line here is that without sufficient financial literacy, the best financial data doesn’t provide any value because you can’t utilize it effectively. There are tons of places to learn such as free online courses, or sitting down with your CFO and third-party CPA. Possibly you just want to learn on your own, which would mean at a bare minimum understanding at least:
- Balance Sheet
- Income Statement
- Cash Flow Statement
- Budget and Projections
- Key Performance Indicators (KPIs) and Performance Measurement
Understanding The Balance Sheet
The balance sheet is a snapshot of your company’s financial standing at a specific moment in time. It shows the assets the businesses have generated from inception to this point, as well as liabilities and equity. Current assets are everything that you own that will be converted to cash within 12 months such as receivables, short-term investments, and inventory. Non-current assets are held for longer periods such as fixed assets like real estate or equipment etc., goodwill, patents, and trademarks. Liabilities include all money owed by the business including but not limited to accounts payable – bills you haven’t paid yet- along with outstanding loans and capital leases. Owner Equity consists of what would remain after settling all liabilities if the company was dissolved. The balance sheet is constructed to be “balanced,” meaning that all the assets equal the total liabilities and equity.
A good analogy for a balance sheet is a checkbook register in which each column represents what’s happening with specific accounts over time – think checking account, savings account, etc., showing how much money is available at any given point in time based on past deposits or withdrawals made from those accounts.
While this may sound straightforward this allows for analysis like benchmarking your company against others in the industry or against prior periods. Financial statement analysis allows you to look at various ratios of data points on your balance sheet to assess business performance and interpret the data. One simple example is the current ratio, measuring current assets divided by current liabilities. The current ratio is a liquidity ratio and helps you assess if you have enough cash and assets to meet all your obligations in the next year.
As you gain a deeper understanding, you can do more advanced financial statement analysis.
Understanding the Income Statement for Financial Literacy
The income statement is also referred to as a profit and loss (P&L) statement. It summarizes your business’ revenue, expenses, gains and losses for a given period of time – typically monthly, quarterly, or annually depending on what’s most meaningful for the business. The reporting should be timely and accurate to ensure you have the right data make any changes as the need arises.
Revenues are pretty self-explanatory, but are the amount of money earned in a given period. Information about how much it cost you to produce the revenues are your direct costs (also called variable costs or cost of goods sold) such as labor, materials, etc., while other costs are indirect (also called fixed costs or operating expenses) that are incurred to run the business overall such as your CFO’s salary. Revenues less your direct costs give you a metric called gross margin which tells you how profitable each dollar of revenue is. Then look at the total pool of all indirect costs and see how revenue you need to sell to break even (ie indirect costs divided by gross margin per unit), which is when your operating margin gets to $0.
Learning the basics of financial literacy, and some simple analysis can give you very meaningful data points about how profitable your business is, and a framework to understand how operational decisions impact the finances of your business.
Understanding the Cash Flow Statement?
The cash flow statement is a critical, and often overlooked part, of your business’s financial statements. While the income statement measures profitability for the period, it’s not on a cash basis (it’s generally an accrual basis) which means it doesn’t measure how much cash is generated from and used by the business. That’s what the cash flow statement does. The cash flow statement outlines how much money has come into and out of the business over a given time period, which helps you understand what’s driving changes in working capital health (the difference between current assets and liabilities) essentially summarizing all transactions into cash from operating activities, financing activities, or investing activities.
At its most basic level, assessing inflows (cash coming into your bank account) versus outflows (money going out), will give you an indication of what activities are actually being converted to cash. As you get more comfortable, more complex analysis can be done which provides deeper meaning.
Understanding the Budget and Projections For Financial Literacy
In order to know if your business is successful, you need an accurate baseline of where things stand now. But equally important is an understanding of where the business is going. A budget provides a framework for projecting future operations and cash flows based on a variety of assumptions. A good budget process requires fundamentally three things. The first is a good model (which can be as simple as a well-designed Excel worksheet). The second is iterating over time to incorporate new data points. Third, and by far the most important, is making good assumptions for the future. Good assumptions require a deep understanding of the business as a whole, as well as a good working knowledge of the business’ financials.
Once the budget is created, it will be used to measure performance and support decision-making throughout the business. Spending the time to do this correctly, takes time and requires a strong base of knowledge. For many businesses however their forecasting process ends at projecting historical data forward with limited changes. That can lead them down dangerous paths where assumptions no longer reflect a reality which means forecasts become less accurate over time and less visibility into the opportunities and risks for the future.
Key Performance Indicators (KPIs) and Performance Measurement
After you’ve gotten a handle on your financial statements and your projections, you now have a number of assumptions about the future and targets you’re hoping to meet (ie how to actually realize your future projected results). You don’t want to get to the end of the year, cross your fingers, and hope it works out. It is important to establish and continuously monitor KPIs. KPIs are metrics that are tracked over time to measure business performance.
KPIs can actually be broken down into two different types: leading indicators (which tell you what’s coming) and lagging indicators (which show you what just happened). Leading Indicators – help indicate where you’re going by tracking metrics like sales pipeline, customer acquisition costs, etc., which give insight into future demand/revenue potential for your company. Lagging Indicators – allow us to understand how we performed against our projections or budget after the fact such as cost per sale margins, total inventory turns, or accounts receivable turnover ratios.
Many businesses make the mistake of only looking at lagging indicators, which can result in a make or break decisions based off past performance. Instead, the key is to build a dashboard with both leading and lagging metrics like sales pipeline versus closed revenue (leading) or total inventory turns (lagging). This will provide you information about how your business trends over time so you know whether it’s following its projected path – ie are things getting better or worse? You can then use that data along with assumptions for next year to identify action steps either financially or operationally going forward.
In conclusion, financial literacy is about creating a solid foundation for decision-making and forecasting, not only in the short term but also beyond. Financial literacy isn’t just about numbers but rather understanding where those numbers come from and why they matter within the overall context of your organization. It allows you to integrate financial data with non-financial data and accurately assess how it all fits into your business strategy. Financial literacy allows you to make informed decisions today with confidence they’ll drive future results rather than just projecting past performance forward. This is important not only to you as the business owner, but for your management team as a whole to ensure everyone is on the same page at the ground level making the right decisions.
