Getting the money right is a concept and idea that sounds relatively straight forward and is, in fact, a concept that every entrepreneur intuitively realizes to be true. This entire book, actually, focuses on the intersection of entrepreneurship and finance and the implications that these connections have to business owners, founders, and managers. That said, we have not truly conducted a deep dive into some of the specific steps that you can take as a managers and entrepreneur to ensure that your business enjoys consistent and profitable growth. Obviously, the topics of accounting, finance, and tax might not be the most interesting or engaging topics for budding and actual entrepreneurs to focus on, but they are of critical importance. Without understanding and quantifying the flows of finance in and out of the business, the best ideas and strategies will not come to fruition. On top of this, and this is where the proverbial rubber hits the road, is that every business is different, and every entrepreneur is different. Additionally, this list is not meant to represent an exhaustive listing of all possible areas that you should analyze when it comes to your business and its profitability—this is merely a starting place for you to begin understanding what is going on with both your business and your business finances.
Before we dive right into financial statements, the components of these statements, and what they actually mean for your business, there is one definition I want to toss out there. The idea of an opportunity cost again might sound like something taught in an economics course, and quickly forgotten soon after. As an entrepreneur, or anyone seeking to expand and grow themselves outside of current roles and responsibilities, however, means that you are already taking into account the idea of opportunity costs whether you realize it or not. For our purposes, here is a quick definition:
Opportunity costs are the price you pay for undertaking a certain course of action, and will absolutely have a strong effect on your performance as an entrepreneur and as business manager. For example, if you decide to start a new business instead of remaining employed, the salary that you are giving up is your opportunity cost. The idea of an opportunity costs represents the benefits you sacrifice from one option to go ahead and start another opportunity or option.
With all of that said, let’s take a look and see what you can do, starting today, to help improve your understanding of business finances and the items you should know about to get your money right. Getting the money right, from both an income and cash flow perspective, provides you the resources and expertise to help grow your business—let’s take a look at some of them below.
The Basics
Every entrepreneur knows a little something about accounting and finance, otherwise they would not have ever had the idea to start the business in the first place. Before we start analyzing, in too much detail, the techniques and tactics for entrepreneurs to help jump-start business finances, we should review some of the basics. Even if you are familiar with these items, I suggest you at least give them a brief review to make sure that we are all working off of the same thing moving forward. A few minutes of reading and thinking is well worth the financial benefits a better understanding of these terms will provide.
Balance sheet—this is the document that shows and lists the assets, liabilities, and equity of the business, and does so for a specific date in time. Remember that, the balance sheet is only accurate for the specific date that is listed on the document, nothing else. For that reason, this financial statement is often described as a snapshot of financial performance, as opposed to a short film or running commentary.
Assets—The best definition of an asset that I have come across is that an asset is a future economic benefit. Some books and academics will say that it is something a business owns or controls, and that can also work, but in a business environment where so much of business is digital and cloud based, I think the concept of future economic benefit provides much needed flexibility.
Liabilities—Mirroring the definition of assets that we are working with above, a liability can be thought of as a future economic detriment to the business. Put another way, liabilities are any funds that the company owes to an outside party, or funds that will have to be paid back at a certain point. If you have a business credit card, a small business loan from the SBA, or have borrowed money from individuals or banks your business has liabilities.
Equity—Equity, in strictly accounting terms, is the residual equity that you have in your business, and represents the difference between your assets and liabilities. So if you have to liquidate your business tomorrow (hopefully that will never happen), whatever (hopefully) positive difference is generated by paying off your liabilities with assets would be your equity.
1. Depending on how complicated your business eventually gets, you might come across, and probably have heard of the concepts of common stock, equity investments, and retained earnings. Common stock and equity investments can be thought of as equivalents for our purposes here—these are funds that have been invested into the business by external parties and do not have to be paid back, unless that was a condition of the investment in the first place.
2. Retained earnings, as opposed to common stock or equity investments, usually does not get the same type of coverage or analysis, but is arguably more important for a small to medium size business and entrepreneurs. Retained earnings simply represent, and are, income that has been generated by the company that have not been paid out to external parties in the form of dividends. Note: Retained earnings are only increased by income that is generated by the organization and not external investment.
Income statement—the income statement is where all of the action for a business takes place, in the form of revenues, expenses, and hopefully a tidy profit at the end of the day. An important distinction between the income statement and balance sheet is that the income statement covers and illustrates the performance of an organization for a period of time, and not just one specific date in time. A critically important part of the income statement is a concept known as the matching principle that states all revenues and expenses for a certain period of time—month, quarter, or year—must be recorded in the appropriate period. A failure to follow the matching principle is a failure of GAAP accounting, which are the rules and regulations for how U.S. organizations should track their financial performance.
Revenues—revenues are called and labeled slightly differently depending on the specific company in question, but are the sales of the organization, and are recorded at the price that the goods and services of the organization are purchased by clients and customers. Thinking of it in a straightforward manner, your revenues are the sales that you are making to clients and customers. Counted at the price that you sell your products and service at, revenue figures represent the top-line of the income statement, and play a large role in the financial performance of the firm. While revenues are, of course, critically important to the organization and the entrepreneurs who manage and run them, they are only half of the profit equation. As every first year business student knows, the net profit of an organization is calculated by subtracting expenses from revenues. Let’s take a look at what expenses actually mean for you and your business.
Expenses—similar to how you think about expenses for personal finances and financial literacy, expenses are costs that you pay in exchange for goods and services. Again, every first year business student is aware of the importance of acknowledging expenses, tracking expenses, and monitoring the changes in expenses over time, but it is also important to know that there are different types of expenses that might influence both your business operations and financial performance.
1. Selling expenses—while this might seem like a simple idea to talk about, it is important for every entrepreneur to know just how much it is costing you to market and sell your products and services. If you, for example, are spending too much on your selling expenses (either in advertisements or revenue sharing) you might be actually be losing money on every sale.
2. Cost of goods sold—I cannot stress enough how important this classification of costs and your cost structure is for your profitability. This bucket and classification of costs, labeled with the acronym COGS, has to do directly with how profitable your business will be. If it costs you, for example, $30 to assemble your product of service (either in the form of raw materials or software licensing fees) and you sell it for $35 you are not giving yourself a lot of margin for error. We have already talked about selling expenses, and we still have some to go—do not exclusively pursue revenue at the expense of profitability.
3. General and administrative—paper for the copy machine, new themed supplies to hand out to potential customers, the charges for your website, phone, and data, and everything else you can think of are lumped into this general and administrative category. The individual items in this category might not be tremendously expensive on an individual basis, but in total this may represent a hole in your budget that is sapping your profitability.
4. Yourself—As an entrepreneur, small business owner, or an entrepreneur that has bootstrapped a startup into a self-sustaining business also need to have level of salary or earnings to survive on an individual basis. Now it is true that you might be living off of savings or previous investments for the time being, but at a certain point you must be able to pay yourself. This is often forgotten and not discussed by entrepreneurs, and represents an area that can trip up and derail the best and most thorough of plans.
Profit—we have finally reached the bottom of the income statement, and are at the point that every entrepreneur and business person wants to end up at the end of business operations for the period. Profit, income, or earnings (whichever label you like better), is the difference between revenues and expenses during a specific of time. Congratulations! Now that you have earned a profit, you have some decisions to make as to what you actually want to do with these profits. We have analyzed the balance sheet and income statement, but now let’s take a look at the statement that bridges the gap between the two—the Statement of Retained Earnings.
Statement of Retained Earnings—One of the important accounting technicalities to keep in mind as you are running your business and churning out profits is that you have some options with what you actually end up doing with it.
Reinvest—reinvesting your profits back into the business has several benefits that are worth starting. First, by reinvesting earnings into your business you are providing your business with the capital and resources it needs to continue growing, expanding, and attracting new business. Second, by reinvesting your earnings into the business and enterprise you are able to also provide a cushion for the business in case of market turmoil and uncertainty. Most small to medium size businesses I have seen choose to retain most of their earnings, and use current period profits to improve the prospects for future performance.
Pay out—this is a technique and idea that is most often found in more well-established businesses, or a business that has multiple internal and external partners. Paying out a portion of the profits and income that have been generated by the organization to some of the other owners and partners has the effect of keeping partners, who are also part owners of the company, satisfied with performance. Additionally, by keeping owners and partners satisfied and happy with current business performance, they are more likely to contribute their time, energy, and finances to help the business grow.
Now that we covered what your options are when you have generated a profit from your startup or small business this is a good time to briefly analyze the different sections of the statement of retained earnings. Just like the balance sheet and income statement there are different sections of this statement, and those are retained earnings and common stock. It may sound a little abstract, but as we will see shortly, it really does make quite a bit of sense. These might not be terribly important for you or your business at the present, but might very well become important as your business becomes larger, more profitable, and well established.
Retained earnings—fortunately this is a relatively straightforward topic and area for our discussion and analysis, although it might sound a little more abstract than most entrepreneurs and businesspeople would like. As discussed above, an organization has two choices with what to do with their earnings; pay them out in the form of dividends and returns to owners or reinvest them in the business. Retained earnings, to put it simply, account for net income that has been generated by the organization, but has not been distributed to any owners.
Common stock (invested capital)—I know that most businesses will not have something as esoteric and high level as common stock and stockholders, but you might very well have investors. We will not dive into the intricacies of accounting for partnership capital, accounting for investments of different types of capital (time, money, property), or any of those accounting topics—you could, and there are, entire books on those very topics. For our purposes here, the primary point to keep in mind is that if your external investments of capital, resources, and time you must be able to keep track of these different investments. Accurately tracking and accounting for these different types of external investments is important, but here is the important point. Investment accounts, regardless of their initial source, are only influenced by the capital invested, and not the operations of the enterprise.
Statement of cash flow—we are almost done with this review and analysis of the financial statements, and I know that this might not have been the most exciting section of this book. That said, having a solid understanding of finance, and the finances of your business, is a critically important skill that cannot be overlooked. Developing a new product or service idea is fantastic, and the course passion of many entrepreneurs and business owners, but an idea is just a start—it requires financing to fully develop and execute on these different ideas. To this point, we have been analyzing the financial statements as they relate to net income and the various iterations of financial performance that originate from this accounting version of net income. Income, as fantastic and easily understood as the idea is, does not represent something that an entrepreneur can pay bills with. Cash flows, which are the cash inflows and outflows of your business, represent what you are actually able to pay bills, employees, and vendors with—so let’s take a quick tour of the statement of cash flows. This financial statement is also presented over a period of time, but focuses on the changes in cash that occur during the period, and does so by breaking down cash flows into three broad-based categories.
Operating—cash flows from operations represent the most intuitive portion of the statement of cash flows, and this is because this section is directly linked to the actual operations of the business. Operations, regardless of the specific industry or field that your business operates in, are where you would like to generate the majority of profits and positive cash flows. Building on this sentiment, cash flows from operations represent the actual cash flows that you and your business are able to generate from your core/primary business operations. In general, this section of cash flows should be positive, as it links directly back to the actual business that you are doing.
Investing—the middle section of the statement of cash flows can be one that trips up even the savviest entrepreneur, and that is because it requires stepping out of owner shoes, and truly analyzing a business from the perspective of the business. Investments, from the perspective of the individual, are cash flows (going in or out) linked to actions undertaken regarding fixed assets—plant, property, and equipment. Framed in this context, a negative or positive cash flow from investing activities is not necessarily a good or bad thing. For example, a negative cash flow from operations might indicate that a firm is investing heavily in expanding fixed assets and infrastructure, and this might be done for a host of valid and progressive business reasons. A positive cash flow might, conversely, indicate and illustrate that a firm is divesting certain fixed assets, which can either indicate a retrenchment of business activities or simply divesting certain fully depreciated assets. In short, this is an area that requires additional analysis.
Financing—cash flows from financing activities are not usually cash flows related to either core business activities or investments made on behalf of the business. Financing cash flows are cash flow activities linked to equity and debt instruments, and this can include items including stock issuance, stock buybacks, cash dividends, debt issuance, and the retirement of certain debt items. It is also important to understand that, similar to cash flows from investing activities, that the financing cash flow section cannot be broken down into a simple negative versus positive analysis. For example, issuing new debt will show up as a positive cash flow figure on the statement of cash flows, but might not actually link to positive developments for the business (more debt is always something to watch). Conversely, negative cash flows might simply implicate a paying down of debt (good for business operations), or paying out cash dividends, which will help satisfy common stock holders.
So now that we have conducted a brief review of financial statement basics, including concepts, the actual statements themselves, and what you need to know about them, we can pivot to action oriented tips that entrepreneurs need to know. In order to most effectively put these steps into action, however, a basic understanding of what external users are expecting (financial statements) is essential. Now that we are all working off of the same basis, we can start talking about some of the specific items you should try to keep in mind as you analyze the financial performance of your business.