If you’ve been in business for any amount of time, you’ve been told how important it is to understand your financial statements.
Many business owners try to understand their financial statements, but they struggle.
The frustration grows typically this time of year when they get surprised with at big tax bill.
After consulting with their accountants, they ask the following questions:
If my business made a profit, where is the cash?
Where did all the profit go?
Their accountant tries to explain, but the words fall on the confused ears of the business owners.
Most business owners rely on what is commonly know as bank balance accounting.
They log into their bank account and look at the bank balance.
If there is money in the bank account, they spend money, if there is no money, they don’t spend money.
They continue with this process because it makes sense.
If there is cash in the bank, then that means it’s available to spend.
Why do so many people struggle with understanding financial statements like balance sheets, income statements, cash flow statements, and profit and loss statements.
The rules of accounting are designed for investors.
The rules of accounting are cumbersome for most people.
It should be now surprise that the financial statements are confusing because for most people accounting is confusing.
There are all these convoluted rules.
There are cash basis financial statements and accrual basis financial statements.
Why does it have to be so confusing?
When I get an answer to that last question, I’ll let you know.
Let’s take the income statement which most people know as a Profit & Loss statement or P&L statement.
In my opinion the Profit & Loss statement is one of the most confusing names for a financial statement out there.
Let’s take the name of the Profit & Loss statement apart for one moment.
When you look at the name it is entirely contradictory.
The purpose of the P&L statement is to show if your business made a profit or a loss.
The two major components of this statement are your income and your expenses.
When you subtract your expenses from your income, you will either have a positive number or a negative number.
When you get a positive number your business has a profit.
When you get a negative number your business has a loss.
This is an either or situation.
You either have a profit or a loss.
You cannot have a profit and a loss at the same time.
If I were to rename the P&L statement, I would rename it to P or L statement.
I think this would make things clearer for people.
To call it a Profit & Loss statement is just one of many examples of why people find the financial data so confusing.
Let’s take things a step further.
The income statement leaves certain information out that most business owners need.
Most business owners need to know how much cash their business makes and how much cash their business spends.
The only financial statement that shares this cash uses of the business is the cash flow statement.
The problem with the cash flow statement is it is a difficult to prepare.
Additionally, many accountants don’t know how to read a cash flow statement.
If an accountant who has formal training in accounting has trouble reading a cash flow statement, what makes us think that a business owner with no formal accounting training is going to understand how to read a financial statement.
The P&L statement does a poor job relaying this information because if a business has loans, most of the loan payments go to reduce the loan.
The only portion of the loan payment that shows up on the P&L statement is the interest expense of the loan.
The P&L statement also doesn’t show the tax bill related to profit earned by the business.
If the business owner takes out owner draws, this money doesn’t show up on the P&L statement either.
The worst part of the P&L statement is the most important piece of data comes last on the P&L statement.
The most important data on this statement is profit.
So here we have a convoluted mess with our financial statements.
There has to be a better way.
There is a better way.
Profit First revolutionizes and simplifies the way business owners look at their business finances.
With Profit First we categorize your business finances into the four use of the business’s money.
- Owner Pay
- Operating Expenses
Just think how much better your business will be with a simple way to understand you business’s money.
To learn more, check out my explanation of Profit First click here.