Today we go back to the basics... the basics of financial literacy.

But don't check out, because the majority of people don't get this.

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Back to the (FINANCIAL) BASICS

Some may look at the subject for this week and say “o that’s simple, I got it.” But the beauty of financials is that there is always something new to learn.

With each new set of financials, there is a potential new set of lessons to learn, just waiting below the surface, ready to be discovered.

It’s why I’ve become so passionate about education in this space.

One, being the educator, means I get a ton of reps breaking down financials and trying to distill them. It makes me better.

But two, I get to see your transformations up close and personal. I get to see it when you have a breakthrough. It’s why I’ve ran a cohort for the last 3 years and why I’m running another one at the end of this month.

But first, is there a real problem? Do people really not understand how to read financials?

Yes, absolutely. 48% of small business owners say they don’t understand their financials. And this is only those who admit they don’t understand them. I’d argue an even larger percentage have a deep enough understanding to use them in their decision making process.

And despite me having allll the education in the space possible, I actually understand.

In my first job as a CFO, I sat down with the owner for the first time to review the financials and was left stumped when he asked “why did the gross margins go down?”

Despite all the education in the world, all the book knowledge… it didn’t help me understand the “why” behind the movement. I had to tell him I’d research it and come back later. I left that meeting wondering if that whole time I’d been a fraud. It was so obvious, I should have seen it.

So know, that in discussion, I’m not here speaking from a point of arrogance, but instead from a point of humility. If I didn’t get it with all that background, how could you get it?

As a business owner, you’re much in the same place. You’re supposed to have it all together. You’re supposed to get it. But understanding your financials requires setting aside your pride to admit you don’t understand something as fundamental as your numbers and then taking the time learn it.

The problem is pretty simple: the same people who excel at starting a business are the same people that are most likely to not understand their financials. Starting a business requires a bit of a “figure it out” mentality, so financials are approached with that same mindset.

This sounds good, but there is a big problem with this approach: it works until it doesn’t.

It starts with you watching the bank account. You see the monies go in and out and you get a good sense for how things are flowing.

This gives you confidence that you understand your business… and you do.

But living and dying by the bank account can, and will, backfire.

It’s only a matter of time and if that’s all you’ve ever done you’ll feel lost and helpless.

I don’t want to paint a stark picture, but it’s the reality.

And sometimes it’s not even your fault. I’ve seen business owners bring on advisors who were supposed to know the answers but ended up in over their heads, too.

I’ve seen those who made it work, but market conditions surprised them and they couldn’t react quickly enough.

While understanding how to read your financial statements will help you be a better business owner, it’s not a golden ticket out of your problems. You still have to spend time learning and analyzing. You will still miss things. You will still have surprises and stresses.

But it increases the likelihood of success and in business, that’s all we can do: daily look for ways to improve our chances of success.

FINANCIAL STATEMENT OVERVIEW

Financial Statements don’t just have one purpose. And that can often be the rub: the reason should dictate the view. Today we’re going to be going over them high level, but I want to set the stage for us and get you asking before every time you look at a set: why are we looking at these financials?

The reason is going to drive what you focus on. Today, we’re going to focus on making business decisions.

Each company has 3 financial statements and they answer different questions:

1. Income Statement (Are you profitable?)
2. Balance Sheet (Are you healthy?)
3. Statement of Cash Flows (Where is cash going?)

The way the 3 statements are represented is based on the type of financial you’ve run: cash or accrual basis.

Cash is just like it sounds… cash in and cash out. When you look at a cash basis Income Statement, the following is true:

• Revenue = cash received for service/product
• Cost of Goods Sold = cash paid out for product
• General Expenses = cash spent or credit card being charged

With Accrual Basis Financials, the goal is to match revenue and expense to get a true look at profitability.

• Revenue = work done/invoiced for service product
• Cost of Good Sold = cost directly associated with Revenue
• General Expense = work done/billed

As an accounting guy, I love a good accrual financial, but they may not be right for all businesses. The reality is, accrual financials are more complicated and simple businesses might be better off sticking with cash.

INCOME STATEMENT

Revenue - Expenses = Profit

The Income Statement is typically what businesses primarily look at. It’s a great statement that shows “profit,” which gives you a sense of how healthy the business is.

Revenue is money from sales of product or service.

Expenses, at a high level, are broken into:

• Cost of Goods Sold
• Operating Expenses
• Non-Operating Expenses

When analyzing an Income Statement, there are many things you can be looking for. Today I want to focus on two types of analysis:

• Vertical: compare to expected values
• Horizontal: compare to historic values

Vertical analysis is comparing each number to a baseline, like a budget or as a percentage of revenue.

When I talked about Gross Margins being down at my first CFO gig, the CEO knew to ask the question because he had a baseline Gross Margin that he was trying to hit. He knew that COGS should be 51% of Sales MAX. If it went over, profitability became a real issue.

Horizontal analysis is comparing each number to previous values. It’s understanding how current values relate to previous and if they’re in line with expectation. This helps highlight how spending has changed in the business, whether for better or worse.

When looking horizontally, look at the current year compared to prior years and ask:

• Did it increase/decrease proportionally?
• What conditions changed that would change expenses?

Some other things to consider:

1. What are your product/service costs as a percentage of revenue? Cost of Goods Sold (COGS) is one of the most important numbers out there and can be a substantial portion of overall expense. Knowing how to manipulate COGS is key to knowing how to manipulate your cost.
2. Payroll Expenses: payroll directly relates to people, which means it’s always important. It’s also one that’s hard to reduce, so you have to watch it carefully.
3. Profit: this is THE number, especially with accrual financials. Understanding where your profit is in relation to your industry peers and making sure you’re generating enough cash to pay for the items on the Balance Sheet are key.

BALANCE SHEET

Assets = Liabilities + Equity OR Assets - Liabilities = Equity

The Balance Sheet is a powerful statement that is often overlooked by the amateur.

But the Balance Sheet is actually the TELL ALL statement out of all 3. That’s because, if you include changes from previous periods, it includes all the elements from the Income Statement and Statement of Cash Flow in it.

Retained Earnings, which is in the equity section, includes current year and previous year earnings (or profit). Profit is the bottom line result of the Income Statement, which means that the Income Statement is an expansion of one line on the Balance Sheet.

Sure, we need the Income Statement. But if you would only give me one, I’d choose the Balance Sheet.

So, what does the Balance Sheet do? It gives us a snapshot of the company’s health and financial strength at one point in time.

It’s broken into 3 categories, which are generally self-explanatory:

• Assets: what you own
• Liability: what you owe
• Equity: book value of company

In the same way you can use vertical and horizontal analysis on the Income Statement, you can use it on the Balance Sheet. But, my favorite way to analyze a Balance Sheet is through ratio analysis.

Some common ratios are:

1. Current Ratio (Current Assets / Current Liabilities): this measures your ability to pay obligations due within one year. When it remains above 1 that is a signal of health, but when it gets too high it means you’re using capital inefficiently.
2. Debt-to-Equity Ratio (Debt / Equity): when debt is greater than equity (a number greater than 1), it could be a sign you have too much debt in the business. Compare yourself to industry peers to see how you’re doing.
3. Return on Equity (Net Income / Shareholder’s Equity): this is of the “return on” ratios (ROA, ROIC, & ROCE) and which one you use will depend on your specific situation. Ideally you should be getting returns greater than what you could get outside the business, as our goal should always be to maximize returns.
4. Debt Service Ratios: There are many of these and what’s important depends on your situation. These are key when working with banks and trying to determine what a “healthy” amount of debt is.

The right ratios will depend on the type of business you have. If you can’t seem to find the right ratios for your business, reply to this email with your business and I’ll try and give you some pointers.

STATEMENT OF CASH FLOWS

Net Increase/Decrease of cash during period + Cash at beginning of period = Cash at end of period

This is the least used and least understood statement. The Statement of Cash Flows reflects how cash has moved through the business over a set date range.

I compare it to looking at a bank statement.

You have a beginning balance, then have each transaction. It’s like if you categorized each transaction by what type of transaction it was. The statement is broken into 3 sections:

• Operating Activities (changes related to day-to-day biz)
• Investing Activities (purchase or sale of assets)
• Financing Activities (changes in debt and capital structure)

The changes in cash tell you if the business generated cash or “ate” cash during that period and what categories that cash movement fell under.

The key numbers when looking at this statement are Operating Cash Flow and Free Cash Flow.

We want to be able to generate enough money from operations to fund reinvestment (investing in assets), debt pay down (financing activities), and distributions to owners (financing).

A business that isn’t able to fulfill these 3 functions is a business that’s on the path to failure.

This statement isn’t super important with Cash Financials, as this activity can easily be extracted from the Income Statement and Balance Sheet. But, when looking at Accrual Financials, this statement becomes VITALLY important.

When doing Fractional CFO engagements, I ask for a “normal” set of financials the company looks at and I’ve never been provided a Statement of Cash Flows, even for businesses on Accrual.

By not preparing it, you’re blind to the bank account swings in your business and potentially missing your true cash flow from operations. Relying on profit to understand this isn’t sufficient and can be highly misleading.

KNOW YOUR WHY

Today we focused on setting the foundation. In that, I want to remind you again: WHY you’re looking at your financials determines WHAT you look at.

Understand your why, then determine what matters.

As you get reps, you’ll get better at asking the right questions at the right times.

As a gift to you, I've provided an infographic to help you digest your financials in less than five minutes. Click the image to download:

Hope this helps.

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