What Do Business Success and Understanding Your Financial Statements Have in Common?

Many Americans cherish a dream of business success. According to Business Week Magazine, five of every 10 companies fail in the first five years of business. The leading cause of failure is lack of money. How can you avoid becoming one of the statistics?

One of the key contributors to success appears to be the owner's ability to understand and use his company's financial statements. Making it in today's business world requires more than looking at the bottom line on income statements. It involves understanding and interpreting what the income statement, balance sheet and some key financial ratios really mean. It involves using that information to make informed business decisions. So, if you're not using your financial statements in this way, how do you get started?

The first step is to acquire a good knowledge of what the reports are really telling you. The incomestatement, also called a P & L, profit and loss statement or an income and expense report, is your best starting point. It is the summary of events that happened over a period time. It provides a report of revenue and expenses and is required for tax purposes. The income statement tells how the business is doing and how profitable it is. Information from the income statement can be used to make better-informed decisions about your company's pricing, margin maintenance and expense control.

The income statement is good for showing you information over a certain period of time , but how do you know if your numbers are good or bad? One thing you can do is look at trends by comparing dollar amounts from year to year or from month to month. Another option is comparing your results with others in the same industry. Your best resource is a trade association for your business. When that is not available, another resource is industry standard information from Robert Morris Associates, Inc., available at most libraries or Small Business and Technology Development Centers.

The second critical source of information is the balance sheet. The balance sheet shows what the company owns (its assets), what the company owes (its liabilities) and the difference between them (its owner equity). It gives the financial condition of the company at a point in time. And just like the income statement, if you really want to see a true picture of how you are doing, you need to look at trends. You will also benefit from comparing your statement to companies in your same industry.

However, understanding what information is provided on the income statement and balance sheet is only part of the equation. To truly be able to use financial information to make better business decisions, we often need to look at numbers in relationship to each other. To do that, we need to look at ratios.

Ratios can tell you about the efficiency of your operation. The key is to pick out a few important ratios to track and review in your company. Some good ones to consider are current ratio, which tells you the percentage of current assets versus current liabilities (this impacts your ability to pay your bills); days receivable ratio, which tells you the average number of days customers are taking to pay you; days payable ratio, which tells you the average number of days you are taking to pay your suppliers; and inventory turnover ratio, which tells you the number of times inventory turns over in a year (this tells you how well you are managing your inventory).

Remember what the statistics tell us — success can be tied to sound financial knowledge. Begin your road to success by learning to use your financial statements as the powerful tools they are.

For business courses to help with financial management, visit www.missouribusiness.net/sbtdc/training and go to the finance offerings or contact the Small Business and Technology Development Center near you for personalized assistance.

- Original article by Rayanna Anderson, Director, Missouri State University SBTDC for University of Missouri Extension's Creating Quality newsletter Feb. 03. Reviewed/updated 2/21/08.