Do you ever find yourself staring at your business’ balance sheet and wondering what it all means? If so, you’re certainly not alone!
You went into business because had a terrific idea to provide pharmacy services and make a difference to your community, and because as pharmacists you have the know-how to make it happen!
Over the years we have been fortunate enough to help a number of individuals make one of the most important decisions they will make in their life for themselves and their families. That is helping our pharmacists go into business as a pharmacy owner.
In this process, we meet up with the clients and discuss a number of issues; amongst them are:
- Effective structures
- Borrowing capacity
- Cashflow position
- Tax position and
- Equity position
Now these are important discussion points, which can be answered with the help of the financial statements. However, the question that stumps our clients during these meeting is - “do you understand your financial statements?”
As an owner, knowing what the numbers represent and what they tell you, allows you to drive smart business decisions, become financially literate and sleep at night knowing your position.
So, what are financial statements?
Think of them like a report card for your pharmacy. Essentially their purpose is to show how money has moved through the company and to show that information from different angles. Now whilst financial statements are a historical representation of the previous period, they are, 100% accurate and provide a holistic view of a company’s finances.
The three primary financial statements are:
- the income statement – how did we do?
- balance sheet – where are we at?
- cash flow statement – how much cash do we have?
We discussed the cash flow statement in my previous blog here, so we will focus on the income statement and the balance sheet.
The Income Statement:
The income statement, also known as the profit and loss statement (or simply P&L statement), shows a company’s financial performance measured through revenue and expenses.
It shows whether a business made or lost money during the reporting period and is also helpful in identifying where a business can reduce costs and improve overall performance.
Why is an Income Statement important?
By periodically recording your business’ income and expenses, you have a better idea of how the business is performing financially. You may gain insights about whether there is scope to increase your revenue, cut expenses or pursue some combination of the two.
Lenders often review a business’ financial statements before they consider lending money, and a P&L statement is a typical requirement. It shows clearly whether your business is operating in the black.
Reading the Income Statement:
The best way to read the income statement is to understand each section and how the numbers you see are calculated, but there are a few quick tips to keep in mind as you scan your next statement.
Start at the Top: Is total revenue in line with what you were expecting? Every business should set sales goals for each month or quarter to manage growth. Check your revenue against those goals.
Look at the Bottom Line: The same goes for net income—you should set goals for this too. Check your net income against your goals. Is it close to what you expected?
If your revenue or net income surprises you, it’s best to dig in a little more to find out what changed. Start by looking at your gross profit. Is it higher or lower than last time? That may signal a change in COGS, like a vendor charging more and cutting into your margins. Also take a look at operating income. Were your everyday expenses higher than normal? If so, what caused it?
The Balance Sheet:
Also called a Statement of Financial Position, a balance sheet provides a snapshot of your business assets, liabilities and net worth at a specific point in time.
It’s important to remember that assets are anything of value owned by the business. They might include bank accounts, equipment, stock or trade debtors. Liabilities are debts owed to external creditors (bank overdrafts, business loans, employee entitlements, ATO debts and so forth) but could also include amounts owed back to you as the business owner (Equity).
The balance sheet fundamentally relies on the accounting equation, which says that a company’s assets must equal the sum of its liabilities and shareholders’ equity.
Why is the Balance Sheet Important?
Most businesses produce balance sheets at the end of a quarter or financial year, so they have an accurate snapshot in time.
Business owners should examine their balance sheet regularly to identify areas of concern and errors. Incorrect classifications on the balance sheet might mean corresponding errors in the profit and loss, leading to incorrect tax and GST calculations.
Balance sheets are also critical for borrowing purposes. Financial institutions will look to the strength of your balance sheet when assessing your ability to repay debt.
Reading the Balance Sheet:
Balance sheets also help you to spot trends.
Start with current assets
Can you cover your current liabilities with them? If yes, you’re probably in fine shape for the short-term. If no, you’ll want to dig into your current liabilities more thoroughly. Remember, current assets and current liabilities have a time frame of one year.
Retained Earnings
The retained earnings section, as the name implies, shows the cumulative profits from previous periods. This is also commonly referred to as Owner’s Equity. The one area a lot of our clients have difficulty reconciling.
For example, if at the end of last year (Year 1) your business had $300,000 left in profit after all expenses, taxes, and other costs were paid, but did not have the cash to draw and of this down as an owner, this balance will be categorised as retained earnings or the carried forward balance of Owner’s Equity.
Now in Year 2, you might decide to distribute some out to owners and also you find yourself with another $300,000 in profit, you could see your retained earnings go up to $600,000. What this means is that if in Year 2, the owner decided to draw down $300,000 there would be no tax to pay on this amount as the tax was paid by the owner in Year 1. The balance of retained earnings would be $300,000 at the end of Year 2.
Where to from here?
If you find yourself unsure of how to understand your financial statements or would like further clarification, then contact myself or John below and let us help you understand and uncover your equity position.
Written by Priya Narsing
