My friend started monthly bookkeeper’s reports and put in place some metrics, then communicated these consistently to his team members, each of whom had responsibility for one or more numbers. Within 18 months revenues had doubled, and profits were up 75%. This is the power of operating your business when you know how it’s performing.
You probably understand your income statement, or P&L, pretty well. You bring in revenue, you spend money, and what’s left over is profit. Depreciation and amortization, fixed and variable costs… OK, so even if you don’t understand every line, it’s still pretty straightforward.
Understanding the P&L is only the first stage in a business owner's education. The next is cash flow.
Many owners of “Expert” businesses don’t understand cash flow quite as intuitively. Cash is easy, it’s what’s in the accounts. But the timing of cash coming in or going out, that’s cash flow.
Think of a company developing a product. They spend on R&D and staff and operations before they start to make money, so cash is always going out. If there’s enough to get the product to market, sales start. And then - still later - checks start to arrive. Now there’s cash coming in and the bleeding starts to slow. When enough cash is coming in to fund operations, you’re breaking even. But you still haven’t made up the deficit from product development, so profitability is still a way down the road.
The third stage in your maturing understanding of financial statements is your Balance Sheet. Think about owning a house with a mortgage. The house is an asset, with a value, and over time that value might increase as the mortgage principal is reduced. The difference between what you owe and the house’s value is called equity, your equity in your home.
On your company’s balance sheet, it’s the same – the value of the assets, cash, equipment, minus the debt equals the owners’ equity. In accounting terms, assets = debt + equity. That’s the balanced equation on the balance sheet.
New here’s the thing. Someone valuing your company – a buyer, a banker, a merger partner – has to set that value on something. There are four main value calibrators, value signals, but the one that’s the most objective - and most appealing to accountants - is your balance sheet. It shows how successful you’ve been at building up the company as an asset in itself.
Understanding the balance sheet is the third stage. Using the balance sheet is the fourth. What are the metrics of success? How do you know if your efforts to build a stronger, more productive, more valuable company are working? We'll get to that in a coming blog.
Just like a home, there are Value Signals besides equity: location, newness, school district. A business might have assets like a team or processes or intellectual property that a buyer will like. But first and foremost, a buyer will look at the balance sheet for depreciated fixed assets, long term debt, and retained earnings.
I’ve got a free webinar coming up soon called Financial Statements for(non-expert) Experts to help you understand what levers to pull to improve your financial strength. Find out more by clicking this link. Hope to see you there!