Business owners tend to develop strong relationships with their accountants. usually at least once a quarter you sit down to figure out where your company stands and how much it owes in taxes. You might also meet a couple times a year to plan when you will make certain investments in your business or how you will structure wages so that you get the greatest tax benefit.
For many business owners, the relationship ends there. They leave with a stack of financial statements and reports, and rarely look past the page where it says “balance due” – but it doesn’t have to be that way. As a business owner, you are responsible for your company’s profitability and you, and only you, can make the choice to use the information your accountant provides.
Understanding the numbers your accountant produces can go a long way to helping you be more successful. You don’t need an MBA or a degree in accounting to understand what the numbers mean and how they matter for your business.
The numbers most pertinent to your company’s operations are contained in one of the three basic documents. Your accountant should provide a copy of these with your annual tax return as well as your quarterly.
- Balance Sheet (aka “what you have” and “what you owe”): This document shows your company’s assets as well as how much it owes (the “liabilities”). It is cumulative, meaning that it includes everything from the time you started your business. The balance sheet helps you see very quickly the financial capabilities of your business.
- Income Statement (aka “what you make” and “how much you spend”): The income statement goes by many names – the profit and loss statement, the P&L, the statement of revenue and expenses. Whatever you call it, it will list how much your company makes (your income) and how much it spends to do so (cost of goods sold and general expenses). Your cost of goods sold are those costs that vary relative to your volume of sales (e.g. raw materials), while your general expenses are those that would exist even if you didn’t sell a single thing (e.g. rent).
- Cash Flow Statement (aka “what is left”): This document shows you how much cash you have leftover after everything is said and done. There are different cash flows reported, but the statement basically ties the income statement and balance sheet together and can provide a greater insight into the numbers. For instance, if your income statement is showing that your business is highly profitable but you don’t seem to have much cash in the bank, your cash flow statement will provide clues to why.
Profitability is pretty straight-forward as a concept but there are several terms and calculations commonly used in business which express profitability in different ways.
- Gross Margin: This is how much you have left over after deducting the direct costs of goods from sales. It can be expressed as a whole number or as a percentage. Either way, the higher this number, the better (so long as you aren’t focusing too much on profit maximization, but that’s another topic).
- Cash Flow: This is how much you have left after you deduct the cost of goods sold, your overhead expenses, interest expenses, and other cash items. It is how much cash you literally have in your pocket at the end of the year.
- Net Income: This number shows you how much you make after deducting everything, including non-cash items – the cost of goods sold, your overhead expenses, depreciation, everything.
- EBITDA: This acronym stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization.” It is calculated taking your net income and adding back in interest, taxes, depreciation, and amortization. The idea here is that the interest you pay is a function of leverage, not the company’s operations – you could always refinance to a different rate. Likewise, the taxes you pay are not your company’s fault. EBITDA may sound a lot like cash flow but the difference here is that cash flow includes your change in non-cash items, like inventory and changes in receivables and payables. EBITDA is best used to determine a company’s ability to take on additional long-term debt.