Running a business without an excellent financial statement is like talking about a cricket match without knowing the scoreboard’s information. Knowledge of basic financial statements is essential for an entrepreneur, and for that, you don’t have to be an expert at everything, but you must have a basic understanding of critical elements to ensure you succeed.
It’s also important for the entrepreneurs to have a centralized coding system, commonly known as Management Information System (MIS) that gives summarized reports and key performance indicators (KPIs) to track the financial statements. Besides your basic knowledge, you also need experts who understand balance sheets and other financial statements.
Financial statements are written formal records of the business’s financial activities that provide a review of your monitory position and performance over some time. It’s helpful to quickly understand the income generated by your venture over time, the costs to produce that income, your liabilities, the assets associated with, and inflows and outflows of cash.
Let’s begin with the three most important types of financial statement:
1. Profit and Loss account (Income Statements)
2. Balance Sheet
3. Cash flow statements
Profit and Loss account
Profit and loss account gives you a summary of the revenue, costs, and expenses incurred over a period of time. From a profit and loss account statement, you can know some of the key info – like, the related direct and indirect costs incurred, the revenues, the resultant gross profit, the overheads spent to run the business and the net profits or losses of the venture.
Let’s understand it through an example of an ice-cream manufacturing company. The typical sales for this company during a period will be through the number of various SKUs sold.
The Direct Costs (variable with sales) for the products sold will be– the costs of procuring the ingredients of ice cream, the labor cost for manufacturing, the Sales Staff of the company, plant rent, etc. Similarly, the indirect cost (does not vary with sales) will be – the cost of the corporate office for running the plant.
The difference between the revenue and the direct cost is a gross profit, and it is a crucial element to understand from a financial point of view. As an entrepreneur, you should know your venture’s gross profit and how it grows during a specified period.
Related Article: What is Break-Even Analysis: A comprehensive guide for startup
If your gross profit is high, you can invest more in your business, whereas if your gross profit is meager, you will have an insufficient margin, and the growing possibility of your business will also be low. Under such circumstances, you need to maximize sales to increase the gross profit. Gross profit percentage (gross profit/revenue) is also a critical component that helps you get the business’s performance.
The Balance Sheet is a snapshot of the company’s financial condition. It gives you a summary of the assets and liabilities of your startup as on a particular date. It can be described by looking at 4 components.
1. Fixed assets – The assets of your startup cannot easily be converted into cash, such as land, machinery, equipment, buildings, and other durable.
2. Shareholder’s Funds – It is the amount of equity that belongs to a business’s owners, meaning its shareholders. It is also the “net worth” of your company since it is equal to your startup’s total assets minus its liabilities, that is, the debt it owes to non-shareholders.
3. Borrowings – It is the amount of money your startup borrows from external sources, such as banks, debentures.
4. Net-working Capital (NWC) – It is the difference between current assets and current liabilities of your company. Typical components of current assets could be cash, inventories of raw materials and finished goods, account receivables or debtors, etc.. The current liabilities would-be creditors, accounts payable, or any other short-term provisions or tax liabilities.
Cash Flow Statement (CFS)
The cash flow statement shows you the aggregate data regarding the cash inflows and outflows over a period. As an analytical tool, a cash flow statement is useful in determining the company’s short-term viability, particularly its ability to pay bills. It also helps investors understand how your company’s operations are running, the sources of money, and how it is being spent.
The cash flow statement is partitioned into three segments, namely:
1. cash flow resulting from operating activities – this basically tells the cash inflow or outflow from the business operations, i.e., from sales, production, Interest payments, buying Merchandise, etc.
2. Cash flow resulting from investing activities – these indicate investments in fixed assets / any long term investments
3. Cash flow resulting from financing activities – the money invested in the company either by shareholders or by borrowing through various channels. If any dividend or interest payout to the same is there, it is included here.
Related Article: Working Capital Management: A complete guide
Management Information System
Now it’s clear why an entrepreneur needs to understand and track each of these financial statements to ensure his venture’s success. But as we mentioned above, it is also important for the entrepreneur to have a centralized coding system that gives him summarized reports using which he can make key business decisions. Such systems are typically referred to as management information systems or MIS. It helps entrepreneurs in effective decision-making, coordination, control, analysis, and visualization of information.
Key Performance Indicators (KPIs)
Key performance indicators (KPIs) refer to a set of quantifiable measurements used to measure a company’s overall long-term performance. KPIs specifically help an entrepreneur determine his company’s financial, strategic, and operational achievements, especially compared to those of other businesses within the same niche.
KPIs vary between companies and industries, depending on the criteria of performance. For an entrepreneur, it’s essential to identify the right KPIs and track them regularly to assess the startup’s performance.
For instance, an FMCG company striving to attain the fastest growth in its industry may consider year-over-year (YOY) revenue growth, as its KPI. Contrarily, a retail chain might place more value on same-store sales, as the best KPI metric in which to measure its growth.
Now you know the gravity of financial statements and its metrics. Isn’t it cool? All these metrics are critical to ensure that the business is sustainable in the short and long run.