Timely, Reliable Financial Statements
An underappreciated contributor to small business success.
In sports, a box score translates the events that took place during a game into a standard table of numbers. It tells coaches and general managers how players and teams performed and how those performances contributed to winning or losing.
For a box score to be useful, it has to be timely. It has to be available shortly after a game is played — not days, weeks, or months later. The bigger the gap between the performance and the feedback, the lower the value of the feedback.
A box score also has to be reliable. It has to be a faithful representation of the events that took place. Coaches and managers have to understand and trust the information that a box score contains before it can become relevant to their decision-making.
Thanks for reading origami.ca! Subscribe for free to receive new posts and support my work.
As it happens, box scores are both timely and reliable. It’s impossible to find a head coach or general manager who doesn’t use them to monitor and improve their team’s performance. Every new strategy or tactic used to improve performance reports its results in the box score. “After we tried this new thing, did our team score more? Did our opponent score less?” The box score is where to look.
What the three financial statements say about your business
Financial statements are like box scores for business. They reduce the results of all the effort involved in running a business into a standard set of numbers. These numbers summarize how a business has done (is it winning or losing) and how it’s doing (is it healthy or sick). In a way, you’re what your financial statements say you are. So, as the owner, general manager, coach, and all-around star of your business, you need to have at least a baseline understanding of what each financial statement is in fact saying.
The income statement tells you whether your business made money over a period of time. The period could be a month, a quarter, a fiscal year, the past 12 months. The question the income statement answers is, over the specified period, did your business make or lose money? Did it have anything left over from its sales after it covered all of its costs and expenses? Did you, its owner, win or lose? Profits increase a company’s resources. They allow it to grow and/or return money to its owners. Losses deplete a company’s resources. They force it to either shrink or raise additional money from its owners and/or creditors. Losses, while common in the early stages when a business is trying to find its feet, are a bad sign in later years, especially for a business that isn’t trying to do something innovative or doesn’t have plenty of investor money.
The balance sheet shows, at a specific point in time, the mix of assets your business owns and the sources of capital used to fund those assets. The assets could include cash, accounts receivable, inventory, property, equipment. Your business employs its assets to deliver its specific goods and services to its customers. Assets have to be funded through liabilities or equity, that is, the money for assets has to come from creditors or investors. Some of the liabilities can be long-term and interest-bearing (debt) and some can be short-term and non interest-bearing (accounts payable). Equity can include capital provided by investors and profits that have been retained in the company rather than distributed to owners.
A balance sheet where most of the asset financing comes from equity and there’s plenty of cash or near-cash assets to cover liabilities is a sign of financial health. A company in this position will typically be able to expand and grow its asset base through increasing amounts of retained earnings.
An unhealthy small business balance sheet will show low levels of equity, a negative balance in the retained earnings account, and scant resources to meet the company’s debt obligations. If conditions don’t improve, losses accumulate, the owner’s equity gets wiped out, and the company slides into insolvency.
The cash flow statement tells you whether your business generated cash over a period of time. This is another important and distinct signal for winning. Profits don’t always transform neatly into cash flow. Every business owner that carries inventory or offers credit to customers learns to appreciate the difference between profit, an accounting concept, and cash, a what’s needed to pay bills and expenses concept. Profits can end up sitting on shelves as inventory or sitting in customers’ bank accounts as accounts receivable. The cash flow statement also shows how the company’s cash balances can be increased or decreased through investing and financing activities.
Managing cash flow in the cash-poor early stages of small business is a decisive factor in determining survival or failure. But businesses also get themselves into cash trouble during periods of growth. Even if it’s quite profitable, growth will often require more cash than a business can generate in the short-term. For the high-growth business to remain solvent, this cash gap has to be narrowed and closed, either through higher profits, slower growth, shorter cash cycles, or, most commonly, external financing.
Small business owners who don’t understand or use their financial statements are eventually going to have to deal with investors or creditors whose first ask will be an up-to-date version of these same reports. Why? Because, in my experience, the owners who neglect finance are the same owners who’ll eventually need it. They’re eventually going to run short of cash, and they’re going to need external funding if they want to keep going. And because the providers of capital rely on timely, reliable financial statements to help them assess the performance, health, and prospects of the companies they’re considering for investment.
Why you need timely financial statements
The first stage of business life is about finding something that a customer will value and pay for, delivering it, getting paid, and then finding more such customers — all before money, nerve, and patience run out. Financial statements aren’t always a priority here. But, even at this early stage, that may be a mistake.
Entrepreneurs who set up some type of financial reporting from the outset are usually more experienced, better funded, and more disciplined in their search for an initial foothold. They’re also more likely to either find their product-market fit or pull the plug before taking too much damage. Some level of financial awareness and planning done regularly, even if it’s a spreadsheet of money in and out, will help an early stage entrepreneur decide among her options and possible futures. If nothing else, basic record keeping will save time and energy come tax time.
Once a business has secured a sufficiently reliable means of producing revenue, the focus shifts to generating profit and cash flow along with more sales. It’s at this not quite out of the woods stage where timely financials become a priority, assuming you want your business to succeed and not just survive.
Using your financial statements, you’re going to be regularly setting and updating targets for profitability and cash flow. Then you’ll be experimenting, trying things in your business to move toward those targets. How do you know if your experiments are working? If your timely financial statements show the important numbers moving closer to their targets, they’re probably working. And if your recent actions worked, you keep going; if they didn’t, you try something else. If you hit your current targets, you set new, higher targets.
It’s a tight loop, where the feedback arrives soon after the action is taken — soon enough to determine if the action has or hasn’t been effective, and soon enough to help you decide the next action to take. Timely, then, doesn’t mean once a year or once every few months. That leaves too big a gap between the experiment and the results for the feedback to have an effect. Monthly financial statements in support of monthly planning and adjustments tend to work best.
By ignoring financials and by failing to set and systematically work toward goals, many businesses get stuck in this second stage of business life. They do enough to hang around but never enough to prosper. They instead “[earn] marginal returns on invested time and capital, and eventually go out of business when the owner gives up or retires.”The telltale signs of a business that’s stuck in this survival stage are flattening or steadily declining revenues, below average profitability, low equity on the balance sheet, very little in terms of cash reserves, and below market compensation to the owners who are working in the business. These are all lingering and debilitating problems that trap small businesses and their owners in purgatory.
Why you need reliable financial statements
In the accounting sense, reliable, as I’m using the word here, covers a number of positive qualities expected from financial reporting: faithful representation, relevance, and understanding.Each is necessary before you can use your financial statements to plan your future.
Faithful representation is more of an issue to third party users (investors, creditors, tax agencies) of financial statements who need to ensure that the numbers haven’t been manipulated and that they reflect reality. As a small business owner, you won’t be guilty of manipulating your internal financial statements to present your business in a better or worse light… to yourself. You, or the individual/team producing the financial statements, just need to be on watch for errors and omissions to ensure your reports represent your financial reality with reasonable accuracy. The obvious benefit, once you achieve this, is that if you trust your financial statements, then it’s more likely that the third party users will as well.
Financial statements are relevant when they “make a difference in users’ decisions.” To make a difference, I’ve already covered why they need to be timely and have feedback value. They should also have predictive value. That is, even though they summarize past performance, they should provide a basis for predicting future performance. This is because a small business’s near future is highly likely to resemble its recent past. Therefore, it should be possible to project, with reasonable accuracy, future performance from past performance. What’s more critical here for you, the small business owner, is that you can use past results to target, rather than simply predict, future results. You’re a player in this game working to achieve a desired outcome, rather than an observer, waiting to see how things turn out.
Understanding small business financial statements requires a basic grasp of accounting concepts and a reasonable grasp of how business works. The accounting part rarely gets complicated. A little bit of study, a little bit of guidance from your accountant or bookkeeper, and a little bit of practice making sense of your own reports, and you’ll know enough to more than make do.
The key is to work with the individual or team preparing these statements until you’re confident that the information they’re capturing and presenting reflects your understanding of the business you’ve built, the one you’re now trying to grow. It’s a team effort. It’s your responsibility to raise your finance and business know-how. It’s your financial provider’s responsibility to present the information in a clear, consistent, and concise manner that encourages you to question and engage.
If you feel lost and discouraged when reading their reports, the right course of action isn’t management by intuition. It’s to find another provider. Managing without well-informed financial objectives will keep your business stuck in the surviving stage for more years than necessary.
Once you have timely, reliable financial statements
To start, you can answer a lot of important questions: Does your business make money? Is it profitable? Does it generate cash? Is it growing? Can it meet its financial obligations? Does it need capital? Is it providing a good return on the capital that has been invested so far? Would you buy stock in your company? Would you borrow money to buy stock in your company? Without timely, reliable financial statements, how would you know?
As a small business owner, once you have timely, reliable financial statements, not only can you finally get a read on your financial present, you can now plan and work toward your financial future. You can compare your financials as they stand today to what they need to look like in the coming months and years — so that you can start building wealth in your business. You can set specific sub-goals with specific deadlines to get your financials closer to your ultimate goal.
Each sub-goal is a measurable financial result (monthly sales up by 5%, cash in the bank up by $60K, etc.) that you plan to achieve in a set amount of time (in three months, by the end of the year). Why would this work? There are always demands on your energy and attention in the day-to-day. It’s easy to get caught up, have time pass, and end up not much better off than where you started. The goal-directed approach of shaping your financials constantly returns your focus to what really matters. You’re making things happen rather than feeling like things are happening to you.
The commitment to hit your financial goals has added benefits. To succeed, you have to become a better player in finance, management, and business. You’ll have to come up with challenging but realistic plans to achieve your goals, which means you’ll need ideas and a set of possible moves. You’ll have to make changes to the way you do business, the way you allocate resources. You’ll try things to get new customers. You’ll try things to motivate employees. You’ll develop new processes. You’ll develop new products. You’ll explore new markets.
Through these experiments, you’ll test your theories on how your business and industry work, how your customers think and feel, what they really want. Your financials will show you the results of your experiments. You’ll update your theories as you discover winning moves. Your theories become more accurate, more useful. As your theories improve, you’ll make more winning moves.
“Our money was made by controlling expenses. That and Sam being ingenious.”It’s hard to know which of the two factors was more important to the Walton family’s success. Wal-Mart was extremely good at controlling expenses, and Sam Walton was an extremely ingenious businessman. I think it has to take a bit of both: good financial management and discipline and good business instincts.
Walton “always had a strong bias toward action.” He “never could leave well enough alone” even when business was good. He was constantly “experimenting, trying to do something different,” willing “to learn from anybody;” he “made mistakes but never anything big enough to jeopardize the business.” He selected store managers with the same qualities: practical, determined, innovative. And he made sure, even before the company had formal systems and computers, that each store manager received a monthly income statement as quickly as possible, so that the manager (and Walton) always knew where he stood. (Walton ran the monthly reporting for all his stores from a garage in Bentonville with “three ladies who helped out with the bookkeeping.”)
Walton had tremendous business instincts and the courage and confidence to experiment and push himself and those around him to improve. And he made sure to always know his numbers, so he could determine what was working and what needed attention. In the early days of Wal-Mart, he entered the sales, expense, and profit numbers for each store himself so he’d be sure to remember them.
Athletes, and coaches and managers of athletes, obsessively track their performance, always looking for ideas and techniques to help them improve. Sam Walton was a successful high school athlete in multiple sports. I imagine a state of constant training, pushing yourself, and keeping score came naturally to him.
In the game of business, most of us aren’t going to take the field with Walton’s qualities as an entrepreneur. But we can still follow his example of being willing to experiment and learn. And, like him, we can use timely, reliable financials to guide our efforts to improve. We’d be learning from one of the best.