Financial Statements: Business's Scorecard

What's in this chapter

Now that we know the accounting basics, we can start to get a bit more granular with the scoreboards that accounting provides. We'll review the balance sheet first because it is, arguably, the most important financial statement (we'll get to why in a bit). We'll then move on to the statement of profit and loss (or "P&L") which should tell you everything you need to know about how your business makes money. This will lead us to the statement of cash flows ("SCFs") gives you a much more detailed look at how your cash changed. We'll finish up by reviewing the statement of retained earnings which is a very simple statement, but breaks down changes in the business's equity which can sometimes be important.

The Balance Sheet

The balance sheet is a "point in time" report that gives you a very detailed breakdown of your business's net worth. You can think of "point in time" like you think of your bank balance. You have $100 in the bank today, but you had $50 yesterday, and you'll have $150 tomorrow. Other reports like the P&L contain information over a period of time. You can think of those like "I made $20,000 from my job last year" or "I made $300 in tips last week." The balance sheet primarily refers to the "Invest Time or Money" part of the business machine:

It tells you not only what you own (your "assets"), but how you financed those assets. That is, did you borrow the money and have an obligation to pay someone back (i.e., you bought the assets with "liabilities")? Or did you (or someone) contribute money without an obligation to pay it back (i.e., you bought the assets with "equity")? You always start with the things you own on the left and then describe how you financed those things on the right:

I've always considered the balance sheet the "most important" statement because if you "get it right," all the other statements should be mostly correct as well. This means that if your assets are correct and your liabilities are correct, your equity must be correct as well. Since P&L accounts are just an extension of retained earnings, and we know your equity must be correct, your net profit is accurate as well. You may have classification issues (e.g., you recorded something that should have hit revenue as an expense instead), but those are usually easier to identify and fix. The balance sheet is also the cumulative scorecard for your business, so it incorporates everything your business has ever done into one statement. This is a very powerful view because it allows you to look at one statement and get a brief look at every decision the business has ever made. Lastly, the balance sheet also contains the broadest level of detail of all the statements we'll review (the businesses intrinsic worth, the results of operations, how you financed the business, etc.).

Assets

Assets, broadly speaking, are the things you own. E.g., cash, inventory, buildings, etc. But accountants usually break assets down into the following buckets:

• Short-term assets. These assets include cash as well as anything that we expect will be converted to cash within 1-year.
• Long-term assets. These are assets that we do not think will be converted to cash within 1-year.

You'll note that cash is the driving force behind what's considered long-term or short-term. That's because, as you've surely heard, cash is king. Cash determines how fast you can grow and not having enough cash can drive you out of business because you grew too fast or you just couldn't pay your bills. So we always want to have a clear sense of how much cash we have now and how much we'll likely have in the next year.

The most common short-term assets include:

• Cash. Self-explanatory.
• Accounts Receivable. How much money you are owed from your customers.
• Inventory. Items you have in stock to sell or manufacture.
• Prepaid Assets. When you pay for something now that has benefits in the future. E.g., if you pay your insurance bill now, but it covers the next 12 months, you would want to show it as a prepaid when you pay it, but then recognize the expense throughout the year. If you didn't do this, it would look like you were significantly less profitable at the beginning of the period and much more profitable over the subsequent periods, when in reality nothing was different except your insurance carrier required you to pay your bill a certain way.

The most common long-term assets include:

• Property. E.g., you buy a building or a piece of equipment that will last longer than 1 year. You will expense this information over time by "depreciating" the asset, but it will take a few years before the asset is depleted. Depreciating the asset means that you:
  1. Determine the timeframe that you think the asset will be useful for (e.g., 3 years). Let's call this the "useful life" of the asset.
  2. Each year you recognize 1 ÷ useful life of the assets cost. For example, if the asset cost you $150 and you think the asset has a 3-year useful life, you would recognize $50 in expense over 3 years.
• Deposits. E.g., you pay your landlord a deposit that you will get back at the end of a 5-year lease.

Our balance sheet now has a little more granularity:

Liabilities

The balance sheet breaks liabilities down just like it does assets: short-term vs. long-term. Short-term liabilities are things that you expect to pay for within the next year, while long-term liabilties are things you expect to take longer than a year to pay. The most common types of short-term liabilities include:

• Accounts Payable. Bills from your vendors.
• Accrued Expenses. E.g., if you pay your sales people commission for June sales in July, you need to "accrue" for commissions at the end of June. All this means is to record a journal entry in your ledger that credits "Accrued Expenses" (or whatever account you decide) and debit "Commission Expense." Your sales people will not send you an invoice, but you need to recognize the expense in the proper period.
• Deferred Revenue. If your customers pay you before you complete a service, you should credit deferred revenue (a liability) rather than revenue since the work is not done (but you are obligated to complete it). This is one that tends to trip people up, but it makes sense when you think about the fact that you still have work to do before the payment is truly "earned."

You may decide to break out accrued expenses into more granular accounts (e.g., accrued sales tax, accrued wages, etc.), but sometimes you will just record it all into one account and then maintain a spreadsheet to support the balance.

The most common-type of long-term liabilities include:

• Notes Payable. E.g., loans from banks.
• Deferred Tax Obligations. Taxes owed but that won't be paid in the next year.

The Statement of Profit and Loss

The P&L does not contain the same breadth of information as the balance sheet, but it provides a much more granular view of how you made money during a period. While the balance sheet shows information in a point in time, the P&L tells the story for a period of time (e.g., this month or this quarter or last year, etc.). Many accountants like to break the P&L down into the following sections:

• Revenue. This is how much you sold to your customers (either services or goods or whatever).
• Cost of Goods Sold. These are the costs directly related to your revenue. For example, if you are a retailer that sells candy, your cost of goods sold is equal to what you paid for the candy before you sold it. If you are a consulting business, your cost of goods sold is equal to the amount you paid your consultants to service your clients.
• Gross Profit. Gross profit is the amount you are left with when you subtract cost of goods sold from revenue. It is a critically important measure that we'll discuss in the financial ratios section.
• Operating Expenses. These are the costs directly related to running your business, but that are not directly related to selling your service or product. For example, your rent expense, insurance expense, payroll processing fees, marketing costs, etc. You need all of these things to generate revenue and run your business, but they are not part of the thing you are selling.
• Operating Profit or EBITDA. This is the amount you get by subtracting operating expenses from gross profit. It is also called "EBITDA" (pronounced ē-bih-dah) which stands for "earnings before interest, taxes, depreciation, and amortization." This is a very important metric for many private equity firms because of the method in which they purchase companies. It is also important because it allows you to compare companies with a similar operating structure that have different capital structures (i.e., more or less debt) or that operate in different jurisdictions (i.e., have different tax rates).
• Depreciation and Amortization. These are the expenses associated with your long-term assets. Even though these are a necessary part of running your business, breaking them out into a separate section helps us isolate expenses that we incur and pay for every year from those that we incur each year but only pay for every few years.
• EBIT. EBIT stands for "earnings before interest and taxes." You calculate this value by subtracting depreciation and amortization from operating profit.
• Interest Expense and Taxes. These are the only expenses that you will incur that we haven't discussed yet. Interest expense is the amount you pay your lenders each year when you borrow money. Taxes are the amount you pay the government each year for the income you earned. We break these out separate from everything else because 1) you can choose to finance your business differently which can increase or decrease your interest expense, and 2) many jurisdictions have different tax structures, so isolating the tax expense lets us compare similar businesses that operate in different parts of the country (or world).
• Net Income. This is how much you are left with after subtracting all your expenses from all your revenue. This is also the amount that your equity will increase (or decrease in the case of a loss) at the end of the period.

The breakouts above may seem a bit complicated, but

The Statement of Cash Flows

Cash is the ultimate arbiter of a successful business. In How Finance Works, Desai notes that "net profit ... his problems" because it:

1. Contains a lot of judgment. You have to decide how long to depreciate certain assets, you need to choose a method of accounting for your inventory, you have to estimate expenses that you don't have invoices for, etc.
2. Makes it difficult to compare companies with similar operational performance that are capitalized differently. If company A has $100 in revenue and $80 in cost and is financed with equity, and company B has $100 in revenue and $80 in cost, but is financed with debt, company B's net profit will be lower than company A's because of interest expense. But they both performed exactly the same! Company B could get the same exact net income as company A by paying off it's debt.
3. Does not factor in the time-value of money. If I offered you $10 today or $10 in 10 years, you would surely prefer $10 today. You can buy things without waiting, the $10 won't buy as much stuff in 10 years because of inflation, you could invest the $10 today to get back more than $10 in 10 years, etc.

So while a P&L provides valuable information, it's not perfect. You might also think that the P&L would be a good indicator for how much cash your business generates, but you would be wrong. It might be a good indicator if 1) your customers pay you in cash, 2) you pay your suppliers in cash, and 3) your business is very simple. But for most businesses, you'll need to know more to get a good grasp on cash. Here are some of the things that will impact your cash balance that won't show up on the P&L:

• If you loaned your customers any money to buy your products (i.e., you sent them an invoice and gave them some time to pay it).
• Your vendors loaned you money to buy their products (i.e., they sent you an invoice and gave you some time to pay it).
• You bought inventory and still have some left when you review your P&L.
• You borrowed money from a bank to purchase equipment.
• You pay your employees every two weeks and their next pay period ends a week after your P&L ends.
• You made a principal payment on a loan.
• Etc.

So accountants invented the statement of cash flows to give you all the details you'll need to analyze cash inflows and outflows. The report is broken into three sections:

• How much cash you generated from (or spent on) the "normal operations" of the business. This section starts with net income and adjusts it up (e.g., for depreciation expense since that is a non-cash expense) or down (e.g., when your customers don't pay you for everything they bought from you in the period) so that you end up with cash from operations.
• How much cash you invested in (or generated from) capital investments like purchasing equipment. While we add depreciation expense back to net income in the previous section, we need to account for the cash outflows that actually occurred in this section.
• How much cash you received from (or gave to) your equity holders or lenders. After evaluating cash flows from the operations and cash flows from investing activities, the only other type of cash inflow or outflow you might have is from "financing activities." E.g., if you borrowed money from a lender or paid a lender back, it wouldn't show up in operations and it's not an "investing activity." Or if you paid a dividend to your shareholders, you'd need to include that cash outflow in this section.

Bringing it all together: the Mobley Matrix

By now, you're probably thinking that looking at three different statements every month (or quarter or whatever) seems like a lot of work. You're probably wishing that there was one statement that could do it all. Luckily for you, there is — the Mobley Matrix. I can't remember when exactly I first came across the Mobley Matrix, but I do remember feeling like I found the golden ticket when I did. I think I felt that way because of how elegant the statement is ... it captures so much information in so little space that I still have a sense of awe when I see it. The one (big) challenge with the statement is that it is not part of the standard reports you get with most accounting software and so it takes a bit of work to compile. The juice is worth the squeeze, though.

The statement is laid out in 4 columns:

The first and last column contain your beginning and ending balance sheet data:

If you recall from above, if you get the balance sheet right the other statements should be "mostly correct." One of the nice things about the Mobley Matrix is that it helps prove that to a degree by letting you see the bridge from the beginning of the period balance sheet to the end of the period balance sheet. The change in each balance can be explained by looking at either:

• The income statement. For example, if you add depreciation expense to the beginning balance of accumulated depreciation, you should get the ending balance in accumulated depreciation.
• The statement of cash flows. For example, if you add fixed asset purchases from the statement of cash flows to the fixed asset beginning balance, you should end up with the fixed asset ending balance.
• A combination of the two. For example, start with beginning accounts receivable, add revenue (P&L), and subtract cash collections from customers (cash flows). You should be left with the ending balance for accounts receivable.

There are two other tricky parts to the schedule:

1. The change in cash is taken from the statement of cash flows. You get the cash value on the SCFs by completing the remaining portion of the schedule and calculating the change to cash.
2. The signs and formulas in the Mobley Matrix are not always consistent. For example, in the schedule below you can see that the ending accounts receivable equals beginning AR + sales - cash collections. But ending inventory is equal to beginning inventory - cost of goods sold + purchases. The formulas make sense when you review the schedule and think about the results, but you have to be careful if you are creating your own template from scratch.

In addition to getting everything on one page, the Mobley Matrix also makes it easy to calculate your return on assets, operating cash flow, gross profit %, and a few other financial ratios we'll be going over later.

If you are

Summary

We've reviewed the three main statements that you'll want to get familiar with to understand how your business is performing:

• The P&L is the guide that tells you whether you are profitable or not. Your business must be profitable to be sustainable, so you need to monitor it on a regular basis (at least monthly).
• The Balance Sheet is a cumalitive snapshot of your business's health. It gives you insights on your liquidity, solvency, how you are financing your business, and much more.
• The Statement of Cash Flows links what's happening in your P&L as well as your BS to cash. It tells you how much cash you are generating from the operations in the business, how much you are investing in capital expenditures (CAPEX), and how much you are taking from (or giving to) your lenders and investors.

You need all three statements to assess your business accurately. You may be very profitable (P&L), but have an unsustainable business if it requires too much cash (SCFs). Or you may have a profitable business (P&L), but too much debt coming due in the next year or two (BS). All three statements work in tandem and tell you something important about your business, so you need to get familiar with all three. You can use the Mobley Matrix to analyze all three together and see the impact each has on the other, but the best way to analyze all three together is oftentimes with financial ratios, which is why they are up next.