Check Your Company’s Financial Health: Part 2

The All Powerful Income Statement

Last week we dove into the Balance Sheet, which I am the first to admit is a bit of a snore (though very useful). This week we are going to take a look at arguably the most versatile financial report available (queue drum roll)…the Income Statement.

 

QB or Xero or whatever accounting software you are using is going to have a canned version of this report that focuses on your net income for the entire company. What is net income, you ask? Net Income is the profit you make from sales after paying all of your bills.

 

Looking at net income for the entire company has obvious uses and companies’ typically track this on a monthly basis as a pulse check for profitability.

Here is an example of a standard IS report from Xero:

Xero Income Statement

 

But what makes the Income Statement special is its ability to be applied to segments and even single products to measure profitability. Want to know whether your light bulb department makes more than the garden department? The Income Statement can do that. Want to know whether sales of that moon moon t-shirt justify the high printing costs? The Income Statement can do that.

 

With careful collection of revenue and expense data, you can create an income statement for any product or division of your company. I have even produced income statements for sales personnel that show the cash they bring in less their travel and salary expenses. Even a sales superstar can put you in the red if their compensation and expense budget is too high.

 

Here are a couple examples to give you some inspiration for your next Income Statement:

Income Statement by Sales Team

IS Example 1

Income Statement by Product

IS Example 2

Check Your Company’s Financial Health: Part 1

The most basic accounting software is going to be able to produce two reports using the accounting entries you have already made: the Balance Sheet and the Income Statement. These two reports are at the heart of financial reporting.

 

Today we will discuss the Balance Sheet.

 

The balance sheet is a snapshot of a company’s financial position at one given moment. So if you log into Quickbooks and run the balance sheet for January 31st, 2015, the report produced will show your account balances as of that date.

 

A balance sheet is organized into 3 major sections

  • Assets
    • Cash
    • Outstanding invoices
    • Expenses paid before they are incurred
    • Long term investments like inventory, real estate or equipment
  • Liabilities
    • Outstanding bills
    • Customer Deposits on future work
    • Short term and long term debt outstanding
  • Equity
    • Past year income
    • Ownership Shares in the company
    • Current year Income

 

The balance sheet always balances! Meaning Assets = Liabilities + Equity. This is the heart of double entry accounting but for our purposes, we will skip the mechanics.

 

What should you care about?

 

Cash

 

If you run the BS report for the last day of the month, this account balance should match the account balance on your bank statement at the end of the month. It gives you a quick view of how much cash you have in the bank.

 

Hint: I highly recommend having a cash flow budget to help track your spending needs throughout the month. This reports uses your anticipated income and expenses to predict your daily bank balance.

 

Accounts Receivable

 

When you create an invoice in your accounting system, an entry is made in the accounts receivable account to track the total amount outstanding for services or products sold. This account balance can tell you exactly how much cash you can expect from your customers.

 

Hint: AR accounts have a supplementary report called an aging schedule, which will show you how long the invoices have been open. This important information can help you determine how likely you are to receive the payment and who you need to follow-up with for late payment.

 

Accounts Payable

 

This account is the offset to your receivable account. It tells you how much you owe vendors based on how many bills you have entered into the accounting system. I emphasise that last part because if you haven’t entered the bill into the system, it’s not going to show up on the report.

 

Debt & Equity

 

If you have to borrow money to run your business, it’s going to come from two sources: creditors like a bank (Debt) or individuals with an ownership interest into your company (Equity). Both sources are expecting compensation for their contribution but typically a creditor has a set payment plan whereas an equity partner relies on management to disperse unused cash as it is available.

 

Let’s take a look at an example QB balance sheet:

BS Quickbookd

Our dummy company, Pinnacle Construction, has a high cash balance and accounts receivable balance in relation to their accounts payable balance. This suggests that the company has plenty of operating cash to handle its bills. However, when you take a look at the liabilities section, there are two loans listed that will impact the availability of cash and a large amount of outstanding work that hasn’t been completed (contract liabilities).

 

To add to the mix, the net income, which generates from the Income Statement, listed under the Equity section is negative. Meaning they earned less than they paid out for operations as of this date. That expected negative cash flow plus the high loan balances and the possibility of increased cash needs to complete the outstanding contracts should be a red flag. This is a situation where a cash flow projection could save this company from defaulting on its obligations and alert them to potential shortages.
A bank considering extending credit to the company might wonder whether Pinnacle can actually meet its obligations and this is a question the business owner should be asking themselves as well. The balance sheet serves as a jumping off point for you to dig into the details of your finances and truly test the financial health of your company.