Reading Your Financial Statements: What Every Entrepreneur Must Know

As you consider which legal entity or entities--corporation, limited liability company, or limited partnership--you prefer to use for your business structure, the decisions you make will depend heavily on your current financial situation, both personal and professional. But do you process to read a financial statement on your own?

Do you technique to read your own personal and business statements? Knowing how to do this is an essential skill not just for entrepreneurs but for everyone. However, for the entrepreneur having this skill can mean the difference between having a thriving business that continues to thrive and winding up in bankruptcy. The annals of the bankruptcy courts are strewn with cases of entrepreneurs who entrusted their accounting to others and, not knowing how to read the financial statements of their own businesses, were surprised when they found that the business was ultimately unsustainable. The purpose of this article is to help prevent this from happening to you--and to arm you with the skills you need to structure your business to your benefit from the outset.

Your Two Major Financial Statements

There are two major financial statements that every entrepreneur should technique to read and (ideally) prepare or have prepared in their financial software (we recommend QuickBooks):

The earnings report

The earnings report (alias the P&L or profit and loss account Statement) offers a dynamic picture of the ebb and flow of your finances. Briefly, earnings report shows first: A. Your various sources of income Then subtracts from that, B. Your expenses To give you the net result: net income or Loss Typically, it is the result shown on this statement that's the basis for your taxation by state and federal authorities at the end of the year. The net profit or loss (revenue outgo) is carried over onto your second major financial statement: The Balance Sheet.

The Balance Sheet

Offers you a snapshot of cumulative results of your financial activities.

It's made up of two columns: On the left side you've your Assets

On the right are listed your Liabilities and Owners/Shareholders Equity (or ownership in the business).

The two columns must be in balance, which is why this is called a Balance Sheet.

Assets=Liabilities + Equity

It's really quite logical how the Income Statement and Balance Sheet relate to one another.

If you've to use current or long-term assets to pay ongoing expenses during the current year, at the end of the year, the amount of your assets will be reduced by the amount of net loss. On the right side, your Equity has come down too. If you borrowed, say $10,000 to pay current operating expenses, at year end, your assets remain as is, but your liabilities have increased by $10,000, lowering your net Equity or ownership in the company by that same $10,000.

It doesn't take a rocket engineer to work out that if you continue on this path, you'll quickly be in a very painful situation, because Liabilities carry their own cost. The cost of borrowing money is Interest, and if you are fortunate enough to borrow at only 10% interest (on unsecured debt) today, a year from now, you'll have to pay $11,000 to pay off the original $10,000 debt. This reduces your equity still further--unless you have used the borrowed funds to create more assets that increase in value at the same rate as the interest on your debt or, better yet--at a higher rate.

More pertinent for deciding which business entities to use is that you need to figure out both your personal financial statements and those of your business(es). If you find, for instance, that that you've significant salary or wage income in your personal financial statements that's causing you to pay out high taxes (as reflected in your balance sheet), and you expect that your business will generate some significant losses for the first several years, it would be advantageous to you to use a business entity that's a flow-through entity. Losses incurred by your S-Corporation (or, if you prefer, your Limited Partnership or your Limited Liability Company) will flow onto your personal balance sheet to offset the salary or wage income and thus reduce your tax liability.

Moreover, as a whole, if you prefer to draw up a roadmap to getting where you wish to go, you need to know your point of departure. Thus, preparing and understanding your personal and business financial statements is an indispensable first step for your business planning.

©Copyright Azur Pacific Associates 2006
Germaine A. Hoston, Ph.D. is President and Treasurer of Azur Pacific Associates, a consulting and translation firm and distributor of the Secret Millionaire Asset Security System and Eventis wealth-building courses.