Once you are consistently entering transactions into your general ledger, you can start to view your financial reports. Your financial reports tell you how your business is doing at any point in time. They are the key tools you use in your financial system to make decisions and adjust course.

Most businesses have two critical reports: the income statement and the balance sheet. We supplement these with a cash forecast, which we will cover in a future lesson. In this lesson we’ll focus on the income statement and balance sheet.

The Income Statement

The income statement shows you your business’s revenues and expenses during a period of time, and shows you whether you have profit at the end of the period (it’s often called a profit and loss statement for this reason.) The time period can vary - most often you’ll be looking at it on a monthly, quarterly, or annual basis.

In other words, the income statement tells you if you’re making money or not.

Contribution vs. Functional Income Statements

There are two primary ways income statements are organized, depending on who the audience is. The contribution method is the primary method most business owners use in day-to-day operations. The contribution method helps you understand how profitable your products or services are and helps you make better decisions.

The functional method is the method used for external audiences, because it breaks expenses into relevant categories like production, marketing, and G&A. It provides a more standardized view into your business and is easier to understand for people who don’t know the intricacies of your company.

For practical purposes we’ll be focusing on the contribution method.

The General Structure of an Income Statement

Income statements usually are broken into the following parts:

Revenues - money you receive for the products or services you provide.

Variable costs (or direct costs) - the costs you incur to provide the product or service. This includes things like costs of raw materials, sales commissions, subcontractors used to deliver a service, etc. Variables costs are variable because you spend more when you deliver more product or service. If your revenue doubles, your variable costs probably double as well (although you can often find efficiencies as a you scale.)

Contribution margin - revenues minus variable costs. Basically whether a product or service is profitable on a unit economic basis - how much one unit of revenue “contributes” to your business. (Note - you will often hear of gross profit - this is very similar to contribution margin, but there are some nuances that make it less useful on a day-to-day basis. It’s more commonly used with functional income statements.)

Fixed expenses - the expenses of operating your business that don’t relate to producing one more unit of product or delivering one more service. Things like rent, salaries, etc. are included in here.

Operating profit - gross profit minus fixed expenses.

Non-operating income and expenses - things like interest income, depreciation and amortization.

Pretax profit - profit before taxes.

Net profit - profit after taxes. Your “bottom line.”

Using Your Income Statement To Make Decisions

Your income statement tells you how your business is performing. It’s an incredibly useful tool (as long as you capture transactions accurately and compile your income statement in a timely manner.) A couple of suggestions:

Include percentages next to the amounts for each line item. It can often be useful to review your income statement categories on a percentage basis. If you created your Sustainable Scale Model and have revenue allocation percentage targets this can show you how you’re doing relative to those percentages.

Comparing two time periods can often be helpful. Comparing this year relative to last year can be helpful. Or the trailing 12 months relative to the previous 12 months.

Benchmarks can be incredibly helpful. If you know that companies in your industry tend to have a contribution margin % of 60%, you can make more intelligent decisions about your business.

Generally speaking, the contribution margin tells you how profitable your products or services are, and can help influence pricing decisions. It tells you about the economics of the business.

Operating expenses tell you how disciplined you are as an owner or management team, and can help you find places to cuts to improve operational efficiency. It tells you about the leadership and operations of the business.

The Balance Sheet

While your income statement aggregates activity over a period of time, the balance sheet is like a snapshot of your business at a particular point in time. It doesn’t show the movement of money in and out of your business, but rather the financial health of your business at the moment it is compiled. The balance sheet is typically also generated on a monthly, quarterly or annual basis, but it only reflects the state of the business on the date it is created.

The structure of the balance sheet

The balance sheet aggregates three types of resources:

Assets - resources your business controls. This includes cash, receivables you are owed from customers, any equipment or buildings you own, etc.

Liabilities - obligations you owe to others. This includes loans you’ve taken out, payables you owe to vendors.

Owner’s Equity - what you and your investors own

In a balance sheet, assets always are equal to the sum of your liabilities and owner’s equity. The two sides “balance”. This is because if you sold the assets in your business and then paid off the liabilities, what you’d have left over is what you’d own.

Another way of thinking about the balance sheet is as a pool of capital. The left side of the balance sheet tells you what assets you have. The right side tells you where those assets came from. There are three sources - debt, equity, and float. They balance between they’re describing the same pool.

Float Is the least understood - it’s a liability, but doesn’t have an interest rate associated with it. As a result, it’s effectively free capital you can use to grow your business.

An example of float would be insurance premiums - you pay money each month to an insurance company, and they have a liability to pay you at some date in the future. Another example would be collecting a retainer from your customers in advance of doing work - this is technically a liability, but it gives you working capital.

Using the balance sheet to make decisions

The balance sheet shows you the heath of your business. It can tell you things like:

Do you have enough resources to pay your bills in the next few months

How much debt you have, relative to your assets.

On the assets side, a business that is less capital intensive to operate is generally (not always) a better business. For example if you have to buy materials in advance, and then sell it to a retail store, you’re carrying large receivables balances. If instead you can get paid daily, you suddenly have a better business.

A business can improve returns by using someone else’s capital for the owner’s benefit. For example, negotiating with suppliers to pay them after you got paid by the retail customer.

Looking at accounts receivable and payable aging reports can help you identify potential issues.

You can find the company’s debt to equity ratio. Banks consider anything above 1.5 to be risky.

Current ratio - current assets / current liabilities. Tells you whether you can meet your short term obligations. Want to be above 1.

Putting them together

Taken together the income statement and balance sheet give you a pretty clear picture of the business. The income statement tells you the profitability of your business. It tells you if you’re making any money. The balance sheet tells you your liquidity - your ability to pay what you own out of the assets you have. It shows you your financial “health”.