Understanding your financial statements: Overview

I frequently meet with budding consumer products entrepreneurs who ask me questions about finding suppliers or talking to stores or getting press. Rarely does anyone ask me to help them understand their financial statements. And by rarely, I mean never.

As industrial designers, learning how to use financial statements to guide business decisions is just not a competency of ours. Financial statements are emotionless, brutally so. They lack nuance. They reduce the richness of our work to heartless black-and-white numbers. Moreover, we fear that the numbers will tell us to stop doing something when we know in our heart of hearts is the right thing to do, even if it isn’t making much money (yet).

Envisioning the future comes easily to me and is enjoyable, while addressing reality can be tiresome. As a business owner, you must be able to do both, and the objectivity of financial statements makes them useful for evaluating the “reality” piece of the equation.

The three main financial statements are:

  • Profit & Loss Statement (also called Income Statement)
  • Balance Sheet
  • Cash Flow Projections

I’ll devote individual blog posts to these different statement types, but here’s a quick overview of why you should care about each one, with a relatable example to illustrate how they work together.

Profit & Loss Statement (P&L)
I think this is the easiest one to mentally grasp. Basically, it takes your sales and subtracts your Cost of Goods and overhead expenses, leaving you with your net profit.
Why a P&L is useful: If your net profit is a negative number, you’re losing money, which is unsustainable.

Let’s say you graduated college and got a decent job that pays $4,000/month.Your monthly expenses are $3,000/mo., giving you an extra $1,000/mo of “net profit”. If you were spending more than you were making each month, you’d have to borrow money from mom & dad or use credit cards to keep going, neither of which is desirable for very long.

Balance Sheet
I think of the Balance Sheet as describing the overall “health” of your company. It summarizes your assets (things you own, like cold cash or inventory) and liabilities (things you owe, like loans).
Why a Balance Sheet is useful: The Balance Sheet shows you if you are healthy through and through or if you are actually sickly but clean up nice. If you are carrying a lot of liabilities, such as loans, you are being weighed down by debt, even if you are showing a profit on the P&L.

In our scenario from above, I forgot to mention that you have a $50,000 school loan debt and $10,000 in credit card debt. So, despite making a $12,000 “profit” each year, you are still in the red overall since you owe $60,000 to other people. The debts don’t show up on the P&L, so you need the Balance Sheet to get the full picture.

Cash Flow Statement
As a small company, your vendors are going to want you to pay upfront and your customers are going to want to pay you late. That means that even if you show a profit when all is said and done, there will still be times when you don’t have the money you need to pay the bills just because of timing.

Why the Cash Flow Statement is useful: If you look at your statement and see that things are going to be tight in, say, March, you can plan for it by asking for better payment terms from certain vendors or delaying purchases.

In our real-world example, this would be like deciding to use $4,000 of your annual $12,000 “profit” to book an awesome vacation for you and a significant other in February. At the end of the year, you will still have $8,000 profit leftover, but February will be tough since you still have to pay your normal living expenses.

 

This took me a couple of years to wrap my head around, but I think it would have been useful to internalize them earlier. Please leave questions in the comments below and I will answer to the best of my ability!

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

Advertisements
%d bloggers like this: