[MUSIC PLAYING] Hi, there. Oscar from Bench here. And in this video, I'm going to show you how to analyze financial statements for your small business. Once you're used to it, analyzing financial statements will help you plan how to grow your business or spot any money problems on the road ahead. Plus, if you're looking for investors, or to take out a loan, or you're planning to sell your business to people making those important decisions are definitely going to be looking at your financial statements.
So we'll touch on the stuff that banks, lenders, and potential buyers are going to be looking for the numbers that show them that your business is financially healthy. Now, luckily you don't need a degree in economics in order to understand what your financial statements are telling you. I'll walk us through each type of statement and show you how to interpret them. Remember, there are three key types of financial statements.
We've got the balance sheet, the income statement, also known as the profit and loss, and the cash flow statement. Let's practice our financial analysis skills using an example financial statement. Here's one for pottery shop called Chelsea Ceramic Studio. Looking at the balance sheet, there are two key factors that help us figure out how healthy a business is.
Number one is how well Chelsea can pay off her liabilities using her assets, and number two is how well can she pay them off using her equity. The people outside your business, those investors, lenders, potential buyers, they're going to use these factors to figure out how financially healthy your business is. If a business owes more money than it can afford to pay, that's a bad sign.
If revenues are something to slow down, you could be left with a bunch of debt that you can't afford to pay. That's why they're going to want to make sure that you can easily pay off those liabilities using your assets and equity. Now, first, let's have a look at assets. Remember, assets is anything valuable that your business owns. So in this case, Chelsea has $20,000 of cash in the bank, plus she's expecting to be paid $4,000.
So that's accounts receivable. She then has $12,000 worth of equipment, so $36,000 total. Now, liabilities. Chelsea owes $1,000 in accounts payable. That's short term debt. Meaning that Chelsea has to pay it back within a year. She has $10,000 worth of long term debt. Meaning that she has more than a year to pay it back. That's $11,000 total.
So Chelsea has $36,000 of assets versus just $11,000 of debts. That's really good. She owns more than three times as much as she owes. Now, one caveat here is that financial analysts tend to focus on liquid assets. So the closer an asset is to cold hard cash, the more liquid it is.
That means it can be used right away to pay off any debts. To cash in the bank, that's super liquid. Accounts receivable, a little liquid. You'll get the money eventually, but you do have to wait to be paid. Equipment, not liquid. If Chelsea wants to sell one of her pottery wheels, your chance to clean it up, post it online, find a buyer, package it, ship it, the whole nine yards.
There's a lot of hoops that she's got to jump through before she has that cash in hand. So taking another look, Chelsea's $20,000 of cash plus the $4,000 through accounts receivable. We don't count the equipment, so that leaves $24,000 worth of liquid assets versus the $11,000 of debt. Well, that's still a really good number and it's the number that we should really focus on.
As in the event of an emergency, Chelsea has more than enough liquid assets to quickly pay off her debts. Now, let's have a look at liabilities versus equity. This is a lot like liabilities versus assets. In this case, we want to see how much your business relies on outside funding to keep going. Remember, the most basic level. Equity measures the money invested in a company, and that includes any of the company's profits that are reinvested, the retained earnings.
If a company has more liabilities, so it owes more money than it has in equity, that means it's relying more on borrowed money to keep going than it is on money from investors or the company's own reinvested profits. Now, in this case, Chelsea owns all the shares herself. She has $12,000 of capital. That's money that she invested to start the business, plus $18,000 worth of retained earnings. Then there's the negative $5,000, that's the money that she's used to pay herself from the business.
So in total, the pottery shop at $25,000 of equity versus the $11,000 of liabilities. That's a really good ratio. More than twice as much equity as liability. If a lender were to look at this, they'd figure that Chelsea's probably a safe bet to pay back a loan, an investor would see this as a sign that her business is financially healthy.
Next up, the income statement. Now, this matters how much money is coming into your business and how much money is leaving it. Let's have a look at an example. So here's an income statement for a store called Erin's aquarium supply company. Now, crunching the numbers on your income statement can help you figure out what your profit margins are. There are three profit margins to keep track of. You got your gross profit margin, your operating profit margin, and your net profit margin.
You can think of your income statement like the dashboard to your car and there's profit margins are like the gauges. Reading them tells you how well different parts of your business are performing. Now, gross profit margin tells us how much Erin made selling aquarium supplies versus how much she spends on those supplies. Think of it like retail versus wholesale value.
In this case, Erin's revenue is $9,000 and a cost of goods sold is $4,000. Meaning how gross profit is $5,000, which is a gross profit margin of over 50%, which is pretty good. Operating profit margin tells us how much money Erin makes after take into account all the money it takes to run her business, not just the wholesale cost of aquarium supplies.
So that's the general expenses. The $2,250 that covers rent, utilities, and office supplies. After taking that into account, Erin's left with $2,750 of operating income. That's a little less than a third of her original revenue or an operating profit margin of just less than 30%. Now, operating profit margin is your most important profit margin.
Why? Or because banks, investors, and anybody else is going to use it in order to measure how well your business is performing. There are some other expenses that you still have to pay like taxes or like interest payments on debt, but those are much more outside of your control. Now, Erin can't do a huge amount in order to affect how much she spends on taxes and interest payments, but she can affect her profit margins if she sells more supplies, aquarium supplies.
She'll boost her revenue, which means her operating income will be higher. Also, she finds ways to spend less on utilities and rent, she'll also improve her operating income that way. These are the real measures of how well Erin is running her business. Once you've applied taxes and interest expense to your operating profit, you get net profit.
In this case, it's the $1,850. That's roughly 20% of Erin's original revenue at the top, that $9,000. If Erin can keep track of her profit margins, she can see how well her business is performing in different areas. A higher gross profit margin from one month to the next could mean that she's spending less on wholesale costs.
A higher operating profit margin could mean that she's saving money on other expenses. And a higher net profit margin can include both those factors, but it can also show her the interest payments that come down or that her accountant has managed to save money on her taxes. Finally, let's look at cash flow statements. Remember, cash flow statements tell us how much cash moved in and out of your business during a specific period.
Here's an example. A cash flow statement for Shopify store selling high end one of a kind sock puppets. Most important measurement we can get from the cash flow statement is the cash flow margin. What percentage of the money that Suraya made was in cash? This is a really important measurement. As if Suraya starts running into trouble paying bills, so she hasn't got enough cash on hand each month, she'll need to find a way to improve her cash flow margin.
In this, she isn't running into trouble yet. She should still try and improve that cash flow margin is the higher the margin, the faster she's getting paid and the more wiggle room she has in the event of any unexpected expenses come up. It also looks good for potential lenders as they want to know that Suraya can afford to pay her interest payments each month without going into the red.
It's pretty easy to find your cash flow margin, you just take your net income for the month or on the top line of your income statement and compare it to your cash flow. So if Suraya's revenue for the month was $2,000 and a cash flow was $200, that's a cash flow margin of 10%. So for every dollar that Suraya's earning in revenue, she only had $0.10 of cash in hand.
If she wants to improve her cash flow, she'll need to find ways of increasing her revenue, such as investing in advertising, offering promotions, or finding ways to raise prices without losing customers. If you're new to measuring cash flow it can take a while to get used to, but your business will benefit. Is the more cash you earn, the more you'll have to work with and the more stable your business will be from month to month.
Congratulations, you've reached the end of our series on basic bookkeeping. I hope you learned something valuable along the way. Here's a quick recap. Bookkeeping is all about tracking the money that your business spends and earns and where it goes. You've got that information and it's up to date, you can create financial statements. Now, there are three key types of financial statements. You've got your cash flow statements, your income statements, and your balance sheets.
Together, they summarize important information about your business like how much income you made over the course of a month or how much of your assets are in cash versus other stuff like equipment. And at the end of the year, you can use the info from your financial statements and complete your tax return or you can hand it off to your accountant who can do it for you. And it comes the day to day operations analyzing financial statements can help you measure the health of your business.
Plus, if you're going to borrow money, or you're looking to bring on investors, or you're trying to sell your business, those guys are going to be analyzing your financial statements too. So you want to make sure that the numbers are good. With some simple arithmetic, you can calculate financial ratios and margins, they'll help you measure your company's financial health.
Now for some business owners, bookkeeping is a lot of fun, especially when you're just getting started and it can be exciting to peer inside the inner workings of your business. But if your business is growing and getting more complex or your schedule is already packed and you don't have time to categorize hundreds of transactions or not just gives you a headache, well, bookkeeping can be a pain.
If that sounds like you, give Bench a try. We'll pay you up with a team of bookkeepers who will do all your bookkeeping for you. Plus, we'll give you an intuitive app they'll let you track your finances and message your team at any time. I'll talk to you soon.