How to understand your financial reports and improve your financial knowledge
A wall of numbers in a spreadsheet can be intimidating. And the captions to the left of these numbers can be opaque, or just seem like accounting jargon. I’ve been there, and felt these things.
Starting out in financial planning with no prior knowledge of accountancy or reporting feels like you’re getting in at the deep end of a very big pool. But it turned out, for me at least, that getting into planning was easier than I thought. I think though that for people new to finance, perhaps forced down this road by the practicalities of running their own business, there is still a big intimidation factor around finance. And a lot of this comes from the specialist knowledge that seems to be required to tell your gross profit from your operating cash, or your cumulative retained surplus from your closing bank position.
We made Brixx to try and overcome these challenges, and also to teach a little bit about finance as you build your Brixx plans.
A lot of the terror around finance comes from spreadsheets, where one false click can ruin a carefully labelled (or perhaps completely forgotten…) equation and send the spreadsheet’s carefully balanced calculations into disarray. And the truth is, without substantial effort, spreadsheet reports are not easy to build or maintain. Fortunately, you don’t configure reports in Brixx, it’s already done for you. Brixx produces a Cash Flow, Profit and Loss and Balance Sheet report based on the forecast plan you put together.
So – I hope that Brixx helps you get over the hurdle of creating these reports yourself. But there’s still a job left to do that can be daunting if you aren’t a finance professional yourself – and that’s understanding your financial reports.
The big three financial reports mentioned above all tell the financial story of your business – looking at the same business activities from different angles. Put together, they form a multi-faceted picture of your business, each casting the business in a different light.
How to learn about financial reports
So the cause of everything in Brixx reports is hopefully easy to get to grips with. But the financial ramifications of these business activities do take a little getting used to.
This can be particularly true in the Profit and Loss report, which causes even me to do a double take sometimes!
There are three main ways to learn about financial reports:
1. Learn what key information each report is used for
2. Understand what the report lines mean:
3. Learn about the reports by building your business plan
In this article, I’m going to help with no.1 on the list above. Follow the other links above to learn more 🙂
Introducing financial reports with a simple example
Let’s say you buy a car.
On the cash flow, you see an outgoing of cash – either in one lump sum or monthly payments. Simple.
On the profit and loss, you don’t see any of this because what you lose from the car purchase (your money) is matched by the value of what you gain (the car!). Instead, you see a loss each month to represent the car’s value going down over time.
And on the balance sheet, you’ll see a shift in the kind of assets you own, starting with a cash asset, which then becomes a non-current asset (the car) when you purchase it. As the car’s value decreases over time, it’s value on the balance sheet decreases too, which also decreases the equity (value of) the business.
Of course, there are many business activities other than buying cars. But what this example shows that all of these financial interpretations are based on an actual, easy to understand business activity – in this case, a car purchase. The same is true with everything you build in Brixx. You think of an activity that the business does, add some assumptions, and the app translates this into financial reports.
How to use the Cash Flow Forecast
The Cash Flow report is where I like to start because it’s the closet report to the ‘real world’. The Cash Flow measures the flows of cash into, and out of the business. It tracks when these cash payments actually take place, rather than when they are owed.
Key questions the cash flow can answer:
- How much cash in hand the business has every month
- The consequences of projects, payments or purchases happening at unexpected times
- The toll each type of cash flow has on net cash
- Will the business stay afloat!?
Key cash flow information:
The cash flow is made up of several ‘cash flows’ – each representing different kinds of business activity, as well as ‘bottom line’ totals of these cash flows.
Cash Flows from Operating Activities
The day-to-day operations of the business: income from sales, minus cost of sales, minus overheads like rent, electricity, paying interest and salaries.
Cash Flows from Investing Activities
The purchase and sale of assets, investments and income gained from interest on savings are recorded here. These are activities that in many cases are outside of the day-to-day running of the business. Initial asset purchases may be necessary to get the business up and running in the first place or replace existing assets that are crucial to the business (a cafe’s refrigeration system, for example) but they aren’t a regular part of the businesses revenue stream or monthly bills.
Cash Flows from Financing Activities
Financing activities show where the business gets its funding from. Financing is cash received from sources external to the business, like loans or external investment. Financing cash flows also include dividends the business pays to shareholders and loan repayments to lenders.
Cash Flows from Taxation
The tax you pay and any tax refunds are included here.
Income Less Payments
Now, this is really useful. This line shows the net cash movement in any given month, that is, the total of all the cash flows mentioned above. This is great for helping you identify problem periods of the year.
Closing Bank Position
The real ‘bottom line’, Closing Bank Position shows the amount of cash in your bank account/s at the end of each month. If this goes negative, the business has serious problems. This is why cash flow forecasting is so important, especially for small businesses.
Splitting out these different cash flows makes this report easier to understand and also allows each flow of cash to be compared to the others. You may find for example that you have a healthy operating cash flow but the business’ investing activities are taking too great a toll on the business’ net cash flow to continue unabated.
How to use the Profit and Loss Forecast
The Profit and Loss (or P&L, also called the Income & Expenditure Statement) records the business’ incoming revenue and outgoing expenditure each month. It is different to the cash flow in two key ways:
It does not record cash movement but ‘losses’ and ‘gains’ to the business.
It records when payments are owed instead of when the cash actually changes hands.
Key questions the profit & loss can answer:
- What are Gross Profit, Operating Profit and Profit?
- Can the business take on new projects?
- What non-cash losses is the business suffering?
- How are dividends related to profit?
Key profit & loss information:
Gross profit is revenue from sales minus the direct costs of those sales. This is often formulated as a percentage called gross profit margin, showing the cost of selling as a % of the sale.
Operating Profit is Gross Profit, minus any indirect overheads (cost of goods, services and salaries).
Operating profit shows how well the business can support itself by its activities alone and is, therefore, a useful gauge for whether a business can take on new projects or other costly activities.
Profit takes into account all of the business’ extra expenditure that is not taken into account under Operating Profit. This includes investments, interest charged, interest received and taxation.
How to use the Balance Sheet Forecast
The Balance Sheet shows what the business owns (Assets), what it owes (Liabilities) and how much has been invested into it (Equity).
Key questions the balance sheet can answer:
- Value of the business’s assets
- Size of the business’s debt
- What funds the business, debt or investment?
- How risky is the business for investors?
Key balance sheet information:
Assets are what the business owns. Assets include physical things like cars and computers, and also cash and investments.
Liabilities are what the business owes. A business with a large ratio of liabilities to assets may be seen as risky as it funds itself with debts which must be paid off, no matter the state of the business.
Equity shows the net value of the business. It’s the same figure as net assets – the businesses’ assets minus its liabilities. Breaking down equity further, it shows who owns the business, whether this is a single owner or a group of investors.