Reading basic financial reports comes naturally to me. Though I have spent thousands of hours honing my skills, I cannot claim credit – it is just the way I am designed.
Business owners and managers often ask me to explain how to use their basic financial reports to manage the business. They know that they are missing something, but they do not know exactly what is missing. I will address those issues in a series of blog posts, beginning with this one.
To move from the academic to the practical, I discuss the reports in the context of the commercial landscape industry. Even if you are not in this industry, you will find valuable principles that you can apply to your industry below.
This week, I cover the basic financial reports. In the coming weeks, I will cover reports that look into the future – revenue growth reports and profit catalyzing reports. But it all starts with the basic reports automatically generated by your accounting system.
The Basic Financial Reports
Each basic report will answer one of two questions:
- What happened?
- Where are we?
Here is an overview of the three basic financial reports and their definitions.
The income statement is like a video. It’s a record of what happened during a specific period, generally a month, a quarter or a year. It shows how much revenue the company earned and the amount of expenses the company incurred. It contains all transactions recorded during the specified period. It is not the existence of a standard income statement that provides value. It is the structure and customization of the income statement to a specific industry and company that makes it valuable.
If you do not see value in your income statement, there is probably a problem with its structure. For the commercial landscape industry, that means showing revenue by type of service: maintenance, enhancements, irrigation, construction and snow removal for those in snow country. Expenses should be divided into four clear segments: direct costs, indirect costs, sales and marketing costs and general and administrative costs.
Direct costs are those costs directly related to a specific customer (such as labor, materials, and subcontractors). Indirect costs are related to performing work for customers, but these costs cannot be traced to a specific customer (such as fuel, equipment, and repairs). Sales and marketing costs include all expenses for generating leads and acquiring customers. I recommend tracking these costs as a separate segment so that you know exactly how much it costs to generate new revenue. Knowing this information also helps quantify the cost of losing customers. General and administrative costs include everything else – the owner’s salary, administrative salaries, office and yard expenses, insurance, coaching and professional fees, etc.
Cash Vs. Accrual Accounting
Some companies track revenue and expenses on the cash basis. This means that the company records revenue when it receives cash and expenses when it pays for them. I do not recommend the cash basis of accounting because the income statement will not reflect reality. (To be clear, landscape companies almost always want to use the cash basis for income tax purposes, but the cash basis should not be used for internal reporting.)
The alternative to cash basis is the accrual basis of accounting. This means that the company records revenue in the month in which the service is performed and records expenses when the company receives the benefit of those expenses. Under accrual accounting, expenses are matched to the revenue generated.
Bad Finance Habits
In landscape companies, I have noticed two bad habits: not accruing payroll and not recognizing depreciation expense at the end of each month. These two bad habits guarantee to produce three really poor months. Here’s why: the company will have two “three payroll” months each year. Plus, the company will record vehicle and equipment depreciation in December each year. Recognizing 42 days of payroll and 30 days of revenue makes for an ugly month. Recognizing 12 months of vehicle and equipment depreciation in one month also makes for an ugly month, because this industry uses much equipment. I find that most companies have these bad habits because they do not think they can get accurate information. The easy answer to that issue is to estimate the amount. It is better to record something than nothing.
Having three ugly months is depressing. These three ugly months mean that the remaining nine months have profits that are artificially high. This situation makes the income statement a far less useful decision-making tool than it ought to be.
The balance sheet is like a snapshot. It’s a record of the company at a specific point in time, generally at month end. It shows the amount of assets – such as cash, receivables, inventory and equipment, the amount of liabilities like accounts payable and debt, and the amount of equity.
The balance sheet is most helpful in evaluating the financial condition of the company. I use the balance sheet to assess a company’s ability to absorb surprises or economic downturns.
One measure is the ratio of debt to equity (i.e. total debt / total equity). Debt includes loans secured by accounts receivable, vehicles, and equipment. Equity is the cash the owner used to start the company plus the accumulated earnings of the company, minus the accumulated distributions from the company. The company’s “going out of business” risk increases as the ratio of debt to equity increases. This is because the company is less able to absorb financial and economic surprises.
Another measure is total liquidity – the company’s ability to deal with short-term cash flow situations. Liquidity is the company’s cash balance plus the amount the company can borrow from a bank. You know when your liquidity is low because you spend a lot of time managing cash. This is an activity that produces no value. Liquidity typically goes down when profits go down. When receivables go up or when the company purchases new equipment, then the company’s liquidity goes down.
Statement of Cash Flows
The statement of cash flows is the least understood report. It is also like a video – a record of cash produced and consumed during a specific period. The amounts for cash production and consumption will be similar to the amounts of revenue and expenses on the income statement, but there are important differences.
Often, the statement of cash flows explains why a profitable, growing company experiences cash challenges. For example, a growing landscape company will see its profits “consumed” by increased accounts receivable and investment in new equipment. At a strategic level, this report helps the owner to see how much growth is too much.
Knowledge Empowers You
If these basic reports are structured well, maintained on the accrual basis of accounting, and are produced timely, then owners and managers get a solid understanding of the company’s financial reality. These reports also provide a basis for making company decisions.
In addition, the data in these reports can be used in other reports to ensure the accuracy of those reports. Some of those reports are topics for next week.
What’s your experience with these basic financial reports? What questions do you have? Please comment below.
What should you do if you do not find value in your basic financial reports? Discuss this blog post with your accountant.