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How Do I Read My Books?

by
Sherri Hastings
on
11/21/2017
How Do I Read My Books?

How Do I Read My Books?  

Taking care of your company’s finances isn’t called “doing the books” for nothing: They may be mostly numbers, but it takes a certain ability to actually read them. Your books show you so much more than what you earned and spent over the past year. They are used to compile information that you need for many different purposes, like tax preparation, applying for a mortgage and showing proof of your income, seeking investor funds, or valuation engagements if you’d like to sell your business. But your books can also tell you other information that can prove to be important for business decision-making and affect how you seek out capital.

Here’s what every entrepreneur needs to know about how the information from your books is used and why having properly done books is so important.

Chart of Accounts

Establishing a chart of accounts is the setup for how your transactions will be sorted, first by account and line-item type; then you can make the sub-accounts as general or granular as your needs call for.

There are revenue and expense accounts that show much you earn and spend. But there are also capital accounts that show how much is invested in your business, as well as asset and liability accounts that measure the residual value of your business. These accounts need to be separated correctly so that transactions are posted to the right places and are subsequently showing up correctly on the financial statements. The accounting equation is Assets = Liabilities + Owners’ Equity, and it needs to balance out, but it’s definitely not going to if transactions are being posted to the wrong accounts.

Your chart of accounts will also be shaped by the type of business that you have. A service business will be relatively simple, but if you sell or make inventories, then your books and bookkeeping needs become more complex. The former just needs one inventory account, while the latter needs three separate ones (for raw materials, work-in-process and finished goods.) If your business has a mix of sales and service, your chart of accounts also needs to reflect this.

While overly granular books can cause a headache, such as having 50 different expense sub-accounts when just 20 will get the job done, you also have to careful not to oversimplify the chart of accounts, depending on what kind of business intelligence you’re seeking from your books. For instance, what kind of revenue streams or clients do you want to keep a close eye on? How will you know which costs to mark for cutting?

The Four Financial Statements

Your books, now split up into several accounts, serve as the basis for the four financial statements that external users rely on. These statements are the “income statement” (also known as the “profit and loss” or “P&L statement”), “balance sheet,” “cash flow statement,” “and “owners’ or stockholders’ equity statement.” While all four of these statements are required by the Securities and Exchange Commission for publicly traded companies, most entrepreneurs primarily rely on the income statement and balance sheet for both business and personal needs. Even with larger companies, this is becoming more common as they are staying private and raising multiple rounds of funding over longer time frames before the IPO stage, so they rely on those two statements more. Nevertheless, the cash flow and owners’ equity statements are more prevalent among larger companies.

The income statement is your main reference for preparing business and personal tax returns and other tax-related documents. This statement simply nets all of your expenses against your revenues and shows how much your profit or loss was for the year or other time frame selected in your bookkeeping software. Most of the expenses taken on your books will translate directly to your tax return, but there are some differences with tax accounting and books balances, such as depreciation on fixed assets like vehicles and equipment, and only being able to deduct 50 percent of allowable meals and entertainment expenditures. Non-deductible expenses are still recorded on the books and accounted for on the income statement, but do not translate to deductions on your tax return. This statement is examined to not only determine how profitable your company is but also where your money is coming from and going.

The income statement also uses acronyms like “EBIT” (earnings before interest and taxes) and “EBITDA” (earnings before interest, taxes, depreciation, and amortization), where earnings refer to the net income to lend a more accurate depiction of operations.

The balance sheet refers to your company’s residual value based on how much your company’s assets are worth, as well as what your total equity is and what you owe in liabilities. The value of your cash, receivables, inventories and fixed assets (less any accumulated depreciation) go on the balance sheet along with liabilities like vendor notes, business credit cards and loans, and your or other owners’ capital contributions. While the market values of these assets may be different from what’s on the books, having the actual purchase price as well as accumulated depreciation is how you keep accurate records of how long you’ve held these assets relative to how indebted you are and what you’ve invested.

The owner’s equity statement reflects how much you’ve invested in the business over time, along with the contributions of any other owners. Then, at year-end, when closing out the books, your profit or loss is posted to the retained earnings account, and profits increase your overall equity, while losses decrease it.

The cash flow statement refers to where your cash came from and where it went, but in a different manner than the income statement. It’s split up into operating, investing and financing activities and specifically ties back to the cash accounts and the other accounts they interacted with. Where did cash come from in operations, what cash was used for investing in your business, and what cash was gained from financing efforts? This statement is particularly important if you’re seeking your first or subsequent rounds of funding from professional investors.

Key Ratios

Even if you’re not using the most robust bookkeeping solution on the market, as long as your chart of accounts is set up correctly and is producing accurate financial statements, then you can determine key ratios. These ratios are often used by banks and investors when deciding whether to invest in you, but they can and should also factor into your business decisions.

Accounts aren’t just split by type, but further subdivided into long-term and short-term (current) categories. Charts of accounts and financial statements are purposely set up with assets in order of liquidity, so cash, accounts receivable that aren’t very old and inventory are current assets. Long-term assets would include equity investments in other businesses and fixed assets like equipment. Current liabilities would encompass notes payable and credit cards, while long-term would be loans payable that you expect to pay off in a year or more. How robust your current assets are is a measurement of liquidity, while your long-term assets with respect to long-term liabilities are referred to as “solvency.”

Activity ratios show how your business is performing with respect to the total value of your assets, how quickly inventory is selling, and how long it takes to get paid. Profitability ratios, on the other hand, refer to performance, with respect to the different measures of income and assets with and without looking at operating expenses. All of these ratios can lend insight to decision-making for long-term goals and current needs.

Liquidity Ratios

Current Ratio = Current Assets / Current Liabilities

Cash Ratio = Cash / Current Liabilities

Activity Ratios

Asset Turnover = Net Revenues / Total Assets

Inventory Turnover = Cost of Goods Sold / Inventory

Receivables Turnover = Net Revenue / Receivables

Solvency Ratios

Debt-Assets Ratio = Total Liabilities / Total Assets

Debt-Equity Ratio = Total Liabilities / Total Owners’ Equity

Interest Coverage Ratio = EBIT / Interest Expense

Profitability Ratios

Gross Profit Margin = Gross Income [Revenue - Cost of Goods Sold] / Net Revenue

Operating Profit Margin = Operating Income [Gross Income - Operating Expenses] / Net Revenue

Net Profit Margin = Net Income / Net Revenue

Return on Assets = Net Income / Total Assets

By having a working knowledge of both the chart of accounts and how each account contributes to these line items on the financial statements, you can gain deeper insights into your business with these key ratios and be able to truly read your books.

Activity Ratios

Asset Turnover = Net Revenues / Total Assets

Inventory Turnover = Cost of Goods Sold / Inventory

Receivables Turnover = Net Revenue / Receivables

Solvency Ratios

Debt-Assets Ratio = Total Liabilities / Total Assets

Debt-Equity Ratio = Total Liabilities / Total Owners' Equity

Interest Coverage Ratio = EBIT / Interest Expense

Profitability Ratios

Gross Profit Margin = Gross Income [Revenue - Cost of Goods Sold] / Net Revenue

Operating Profit Margin = Operating Income [Gross Income - Operating Expenses] / Net Revenue

Net Profit Margin = Net Income / Net Revenue

Return on Assets = Net Income / Total Assets

By having a working knowledge of both the chart of accounts and how each account contributes to these line items on the financial statements, you can gain deeper insights into your business with these key ratios and be able to truly read your books.

Tim Murphy, CPA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].

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Sherri Hastings

Sherri Hastings

Tim Murphy is the managing member at Murphy & Murphy, CPA, LLC, a full-service certified public accounting firm, with emphasis on tax preparation, audits of governmental, educational, and non-profit entities, retirement planning, estate planning, business valuations, litigation support, and banking. He is a Certified Public Accountant in Maryland and Virginia. Tim is also a CERTIFIED FINANCIAL PLANNER professional, Personal Financial Specialist, Accredited Estate Planner, Certified Valuation Analyst, and Investment Adviser Representative.

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