I had been at the job for a few years and regularly ran into the same person on a regular basis.  We frequently chatted about work and life and got to know each other pretty well, except for one little thing; I didn’t know his name.  After multiple conversations, it became awkward for me to ask because it seemed like something I should have known all along.

I have noticed that sadly, a lot of business owners and executives feel the same way about understanding financial reporting.  They hear about it all the time.  They sit in meetings and review financial data.  They may have some understanding of what is going on, but in my experience, many have questions and they are simply too afraid to ask.  In fact, financial literacy is the exception rather than the rule for many owners and executives.

If this is you, your secret is safe with me.  The time to start learning, though, is now. Here are 10 things you should understand to boost your business acumen and help you better understand the language of business.

1 - Profit is More Important than Revenue

Too many business leaders are infatuated with revenue.  One business owner proudly showed me his profit and loss statement over the past few years and showed how he had tripled his revenue.  Unfortunately, his profit was actually less than half what it was when the company was smaller.  While it’s fun to think about growing a company, essentially what he had accomplished was he was running a company 3x larger at a higher cost.  

There are certainly strategic times when companies will sacrifice profit for revenue growth, but don’t lose sight of profitability.  

2 - Consider Owner Draws / Compensation in the Business Model

In one week, I spoke to two different business owners about their business.  The owner of Business “A” was super optimistic about her business.  She talked about how she had made money since she started the business 10 years before.  The owner of Business “B” was a lot more pessimistic.  She was worried that their long-time business was declining and was in danger of going out of business.

A look at the financial statements revealed something interesting.  Company “A” did show a net profit, but there was something missing.  The owner had never paid herself.  She was running a business for free.  The profit was not enough to give her any kind of significant paycheck.  Company “B” showed a loss for the past few years, but this time, I discovered that the owner was paying herself an exorbitant salary which was probably 4x what she should have been making based on the success of the company.  If she paid herself a more reasonable salary, the company was actually quite profitable.  

For small businesses, my advice is for the owner to establish a salary for themselves that makes sense based on the job they perform and get used to including that in the profit and loss statement.  If the company is still profitable, the owner can take draws from the business.  If not, the owner should be careful.  Accountants steer too many business owners towards minimizing tax liability and encourage business owners to mix personal and business finances.  While this might be a good tax strategy, it muddies the water on whether the business is actually healthy.  

3 - Understand your Margins

A typical profit and loss statement (also called an income statement) shows revenue, expenses, and profit.  Expenses are often broken up into COGS (Cost of Goods Sold) and Indirect Expenses.  COGS are also called direct expenses in that they are directly related to the revenue.  If you sell a glass of lemonade, COGS include the cost of sugar, lemons, and cups because if you sell more lemonade, your COGS will increase accordingly.  

When you take out the COGS from your revenue, what is left over is called your gross profit.  The percentage of gross profit to revenue is your gross margin.  If you have a 60% gross margin, for every dollar you sell, you will get $0.60 in gross profit.  Unfortunately, business owners know they don’t get to keep all of the gross profit because there are still indirect expenses associated with the business.

Indirect expenses (often just called “expenses”) are not directly related to revenue.  For a lemonade stand, this would include salaries, the stand itself, and the cost of signage used to promote the stand.  These costs are relatively stable regardless of how much lemonade is sold.  For the business to be truly profitable, the owner of the stand should have some money left over from their gross profit after they pay all their indirect expenses.  What is left over is called net profit and the percentage of net profit left versus total revenue is known as net margin.  If a company has a 10% net margin, that means that for every dollar sold, the company will have $0.10 left over at the end of the day.

Understanding your margins is important because it helps you to understand how to make money.  If your net margin is 10% and you want to make an extra $1000 in profit, there are a few ways to do this.  You can sell an extra $10,000 in revenue to make the $1000 in profit, which is the approach most business owners gravitate towards.  

However, the same business can also make another $1000 in profit by cutting expenses.  Every dollar spent in COGS and expenses reduces the profit by a dollar and every dollar saved adds a dollar to the profit.  

We worked with a business whose employees had figured out how to save the company $1500 per year in expenses.  They presented their plan to the executives who kind of patted the employees on the head and thanked them.  When the employees left, the executives went back to looking for ways to boost their revenue.  I asked the executives about their profit margin.  Their net margin was only 1%.  At this net margin, saving $1500 in expenses has the same impact on profit as selling an additional $150,000 in revenue!  If the employees had announced that they had found $150K in new revenue, they would’ve been hoisted on their shoulders, but these executives didn’t realize what they had accomplished.  

4 - Understand 3 Key Financial Reports

Most business owners and executives spend a lot of their time looking at their profit and loss statement, but really, there are 3 financial statements that are required to run a business.  

The first financial statement is the Profit and Loss (also called a P&L or Income Statement).  The P&L essentially tells you if the business model is working or not.  The P&L is generated showing a period of time showing revenues, expenses, profit, and margins.  Unfortunately, the P&L is not enough to show you if a business is successful.  In fact, it is possible that your P&L shows a profit consistently and you still go out of business. 

The second financial statement you need is your balance sheet.  The balance sheet shows your equity, liabilities, and assets.  You can think of your balance sheet as telling you what you have (or don’t have).  Your assets show you the things you own that have value.  Your liabilities are the things you owe (such as loans or your accounts payable).  Your equity is what is left over.  The balance sheet is a snapshot at a moment of time.  

The last financial statement you need is a cash flow statement.  The cash flow statement shows how cash will flow in and out of the business.   Cash flow is different from revenue and expenses in that it shows actual cash.  A construction company, for example, might win a bid for a $10MM job.  If they are using accrual accounting, they will likely book the revenue as soon as it is won and show a tremendous profit.  However, the construction company will be the last to get paid.  Before they get paid, they will need to buy materials, pay for labor, and pay subcontractors.  The cash flow statement allows them to plan and make sure they have enough money on hand to get the job done so they can earn their $10MM at the end of the day.  

You need all 3 statements to truly manage the business.  

5 - Depreciation is Real

A doctor’s office we work with purchased a new laser device used for skin treatments.  Let’s say that the laser cost $240K.  The laser is known as an asset and can be “capitalized”, which means it does not appear on the P&L.  Instead it shows up on the balance sheet.  What does show up on the P&L is interest paid on the loan to purchase the equipment and something called depreciation.  

Depreciation is essentially the declining value of the asset.  If the laser is expected to last for 10 years, the depreciation might show up on the P&L as $24K each year.  Because the business doesn’t actually have to pay that $24K, too many business owners and executives say that depreciation is not real.  However, it is real.  Here is why.

Let’s say the doctor’s office ignores the depreciation number in the P&L and breaks even every year.  For 10 years, the doctor will be able to pay his bills, but in 10 years, he will need to purchase another laser.  If he doesn’t have the profit to buy the laser, he will need to borrow the money again.  This means that for 10 years, this company will have actually lost money because of that laser.  

Depreciation gives you a long term projection of what your business will need to earn to to maintain its assets.  

6 - Cash vs. Accrual Accounting

It’s important to know what type of accounting system you are using.  There are 2 major types: cash and accrual.  Cash accounting means that revenue and expenses are booked as the cash is collected or paid out.  In a cash system, if you send a bill for services to a client and the client pays that bill 3 months later, the business will book the revenue 3 months after the bill.  

In an accrual system, the revenue and expenses are assigned to a specific period of time, usually when booked.  In our above example, that means the revenue would be booked as soon as the invoice is sent, not when the cash is received.  The gap in receiving and paying cash is why it’s important to understand your AR (accounts received) and AP (accounts payable).  AR is money you have billed but not yet received (it’s an asset) and your AP is bills you have collected to pay but haven’t paid yet (it’s a liability).  Both show up on your income statement.  

7 - Accounting is not a Hard Science

One of the surprising things about accounting is that it’s not an exact science.  In fact, you could call it an art.  Accounting systems are designed to “account” for everything you do, but many systems are poorly designed to help you run your business.  If you can’t make heads or tails of your financial reports, it might be because your accounting system is designed poorly.  I’ll give a simple example.

At People Centric, we often travel to visit clients and most of that travel is reimbursed by the client.  When we first started the business, we counted reimbursed travel as both a revenue and expense.  If we incurred $5K in travel expenses in April, it showed up as an expense in April.  If the client reimbursed those expenses in June, it showed up as revenue in June.  

The ups and downs of our travel expenses introduced a lot of noise into our revenue and expenses even though they ultimately cancel each other out.  I remember one month when a lot of clients paid their travel expenses at the same time resulting in our best revenue month ever.  I congratulated our team for the good work, when in fact, we really hadn’t done anything differently that month.  

So we changed our system.  Instead of reporting the revenue and expenses as part of our normal P&L, we took reimbursed expenses “below the line”.  This means we calculate our net profit without considering reimbursed expenses.  We still account for the reimbursed expenses, but they no longer impact our net profit resulting in clearer financial statements. 

8 - Your Accountant Might Not Be Doing What You Think 

You might want to sit down for this one and I might upset a few of my accountant friends, but here it goes.  Your accountant might not be doing what you think they are doing, especially if you are running a small business.

Most accountants are focused on tax preparation.  Running a set of books that meets tax code is not the same as running a set of books that helps you to run your business.  Most accountants have many clients and it's in their best interest to keep your books simple while meeting tax code.  But that might create murky reports that keep you from making good decisions.

A simple example occurs at People Centric in terms of meals purchased by our team.  Meals purchased for legitimate business reasons are an expense that is tax deductible.  Our accountant doesn’t care why the meal was purchased as long as they know it is an expense and it is deductible.  

However, we do care why the meal was purchased.  Some meals are purchased as part of our sales activities.  Some are purchased while our people are traveling to visit clients.  Others are purchased for internal team events.  To help us run the business, we need to know what we spend on sales activities, what we spend on serving our clients, and what we spend on our own team.  So we code these expenses accordingly so they can be properly categorized.  

Most accountants work to keep you out of jail, not to help you gain insights into running your business.  The result is that most small business financial statements I look at are, well, kind of a mess.  

The bottom line is that you can’t outsource your understanding of financials because they are critical to helping you to run your business.  While financials and accounting can be complicated, I hope these simple concepts help you find where you can start. 


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