There are only two rules in business:
Rule #1: Always earn more than you spend.
Rule #2: Never forget rule #1.
To know if a business is earning more than its spending at any given point in time, stakeholders should know the pulse (numbers) of the business and numbers are on financial statements.
Unfortunately, many people find it hard to read and understand financial statements and are very dependent on their accountants. This is mainly because lack of understanding of the basics.
To read and understand financial statements it doesn’t require having an accounting or financial background. You just need to know four critical things happen in every business:
- Money comes in
- Money goes out
- Money’s supposed to come in
- Money’s supposed to go out.
Whenever one of these financial transactions occurs, it gets recorded in a book of accounts (accounting software) and accordingly, two basic financial statements are prepared, namely, a Balance Sheet and Profit & Loss Statement.
If you’re aware of what’s happening in these four areas of financial transactions then you can use a Profit & Loss statement as a thermometer which will tell the temperature of the business, and the Balance Sheet will show why the business has that temperature.
When it comes to reading financial statements, it’s important to understand you are not your business. (Owners are treated separately from their business)
- Money comes in: money can come into the business in two ways,
- When a business sells a product or service and the customer pays for it. It gets recorded under the heading Income on the Profit & Loss statement.
- When a business borrows money it gets recorded as Liabilities on the Balance Sheet.
- Money goes out: if money is going out of your business, it either becomes an Expense or an Asset.
- Expense: bills, salary, interest paid on loans, tax. All these get listed on the Profit & Loss statement as Expenses.
- Assets: purchase of land, building, machineries. These get listed on the Balance Sheet as Fixed Assets.
- Money supposed to come in: Money supposed to come into the business within one financial year. Usually it will be money customers owe to the business, they are called Debtors. This gets mentioned as Current Assets on Balance Sheet.
- Money supposed to go out: money supposed to go out of the business within one financial year. Usually all payables or money the business owes gets mentioned here. It will be under the heading Current Liabilities on the Balance Sheet.
Get on top of these four financial transactions and you will be more confident in making informed profitable decisions in business.
All of that said, good financial management may not always guarantee success in business. However, poor financial management alone can bring down any organisation!