Financial Statements are like visiting the test results from the doctor. It gives you a snapshot of your company’s health but doesn’t tell you how to lose that extra weight or help you deal with that chronic back problem. And for some, even the results of that basic checkup can be a mystery. While some small companies may not even go to the doctor.
In this article, we look at the fundamentals of financial statements, how you can get the best out of them as an online agency or consultant, and how to level up.
Why Financial Statements
Balance Sheets were introduced in 1494 by an Italian monk who invented double-entry bookkeeping.
But it was in the New World where financial statements truly came of age. The explosion of American railway companies and the growth in product distribution that they enabled drove a need for more sophisticated financial analysis.
Many railroad tycoons turned out to be charlatans. This gave companies who used financial statements an advantage in wooing potential investors.
Financial statements also helped those companies that scaled up with the railroads to better track their financial performance. When you have a single location, you can walk in and talk to the people there but what happens when you have branches throughout the east coast of the US?
Today, it is hard to imagine running or investing in a company without financial statements. They provide that 20,000-foot view of a company and provide the foundation for more critical financial analysis. But the devil is in the details.
The Three Main Financial Statements
The three main financial statements are the Balance Sheet, Income Statement, and Cash Flow. They each show different key aspects of your company but they do so in different ways. The Balance Sheet shows a snapshot of your company at a given point in time. While the Income Statement and Cash Flow Statement show you what happened over a period of time (e.g. a month or a year) with your revenue and cost (Income statement) or your cash flows (cash flow statement): flow versus state.
1. Balance Sheet
The balance sheet answers the age-old question: what am I worth? It tells you the value of all the assets your business owns (including cash), and how they financed: what you owe to others (liabilities), and what is financed by you as the owner (shareholder equity). It is summarised by the following formula:
Assets = Liabilities + Shareholders’ Equity
Another way to look at this is If you sold all your assets to pay off your outstanding liabilities, you would be left with your company’s net worth or Shareholder’s Equity.
Assets include physical property like a factory, machinery, vehicles, and inventory. It even includes intangible assets like a patent and good old cash.
Assets are typically sorted into three main categories. These categories help with financial analysis:
- Liquid: cash and things that equivalent to cash
- Current: can be converted into cash within a year, such as accounts receivable
- Noncurrent: will take longer than a year to convert to cash, or are not intended to be sold at all (like your laptops, machinery, or your companies trademarks
Liabilities are sorted in two main categories:
Current – payable within a year (suppliers, team)
Non-current – payable longer than a year (e.g. long term loan)
2. Income Statement
The income statement shows you your company’s top line and bottom line, and everything in between. In other words, it is the revenue you earned over a given period, less the costs of delivering your services and less your sales, general and administrative expenses. It also takes into account interest income and expenses, and taxation.
Your target gross and net margin depend on your specific company, but as a general rule of thumb your gross margin should be 50% or higher to run a sustainable business.
3. Cash Flow Statement
Cash is the lifeblood of your business and the Cash Flow Statement helps you track the inflows and outflows of that precious cash. In other words, it shows you how your cash balance changes over a given period of time.
The Cash Flow Statement is divided up into three main sections representing different areas of your business:
- Operating Activities: Cash Flow from your main business activity. The cash from selling your services less the cash spent in running operations.
- Investing Activities: Cash Flow from buying and selling assets, usually Fixed Assets.
- Financial Activities: Cash Flow from financing debt and equity, such as loan draws and repayment and dividends paid to the owners
Key Financial Metrics
When you get familiar with financial statements, it is like reading the results from your medical check-up: it gives you a good basic picture of your health. But if you want to understand what is happening at a deeper level, you need to look at your blood test with its numerous readings and measures.
Financial ratios are the blood test for your financial statements. It allows you to look a little beneath the surface of your company to get a diagnosis of different key areas of your company. Here are some key financial ratios.
Operating Cash Flow
Are you generating cash from your normal operations?
In the long run, operating cash flow should be close to net profit, but in the short term it can vary greatly (big customer, didn’t pay – do count the revenue, but don’t have the cash flow)
It is critical that this is above 0. Below zero and you are bleeding money every day – in the long your business will not sustainable
Quick Ratio
The Quick Ratio also gauges your liquidity relative to your liabilities but instead of focusing on the cash flow it focuses on your liquid assets i.e. assets that can be converted to cash within 90 days. It asks the question if sales dried up and I had to pay all my current liabilities with cash and everything I can easily convert into cash can I do it? A score of one or more says yes. Below one and you may need to make changes such as increasing your prices.
It can be calculated in two ways using numbers from your Balance Sheet.
= Cash + Equivalents +Marketable Securities + Accounts Receivables / Current Liabilities
OR
= Current Assets – Inventory – Prepaid Expenses / Current Liabilities
Revenue Growth Rate
Revenue is good but revenue growth is even better. What is your target growth rate? Startups like to double their revenue every few weeks but for an established agency and consulting company, target growth rate is much lower. Your target depends on your current size, your long term goals and your specific segment. So rather than fixating on a benchmark, set your own target here that fits you.
Gross Margin and Net Margin
Gross Margin is your basic profit from operations. It is profit before overheads, interest expenses, administration, and other company-wide expenses.
Gross Margin = Gross Profit / Net Revenue
Net Sales Revenue simply means sales revenue net of any discounts and returned items.
Gross margin tells you how profitable your services are. If your gross margin is too low, that is the first priority to fix!
Your Net Margin tells you how profitable the business is after all your overhead and marketing expenses.
Net Margin = Net Profit / Revenue
Net margin is calculated by subtracting all company expenses from total revenue and then expressing it as a percentage over revenue.
Both Gross Margin and Net Margin are useful for determining if you are pricing at the right level or if COGS are too high. It also tells you how much ammunition you have if a competitor is challenging you with prices.
Gross Margin and Net Margin are a good single measure but it grows in value when you apply it to the different niches of your business. You can apply it to individual product lines, clients, locations, etc. By focusing it on specific niches of your business it becomes a powerful diagnostic tool.
3 Top Tips for Online Agencies and Consultants
So far much of this article has been generic to any company but now we look at three areas critical for online agencies and consultants.
1. Revenue recognition
Bookings and billings are not revenue. When a client enters into a contract, the full amount is the sale. When the client pays some or all of the contract, that is the billings, and when you perform some or all of the services set out in the contract, that is revenue.
Proper revenue recognition is important because it provides the most accurate snapshot of your finances. It enables you to see what work you have done (with all the associated expenses) and what revenue you have earned as a result. If you just looked at the bookings, you would have a big revenue number with none of the expenses. Similarly, if you looked at billings, you could have an inflated picture, if the client pays upfront, or a pessimistic picture if the client is tardy with their payments.
Proper revenue recognition also enables you to calculate Monthly Recurring Revenue (MRR) which is a key metric for subscription or retainer-based companies.
For more details check out this previous article I wrote on revenue recognition.
2. Cost recognition
The twin sister of Revenue Recognition is Cost Recognition. Costs should be recognized in the same period as the revenues they relate to. This provides you with the most accurate snapshot of your company’s finances. This timing accuracy is critical to get accurate gross and net profit margins.
For some costs connecting them to services given and revenue earned can seem difficult. How do you assign administration costs or IT hardware costs to a particular service provided to a particular client? The answer is to divide them up into a period cost and apply that cost to the revenue earned in a period.
3. Prioritize Cash Flows over Margins
Remember cash flow is your company’s lifeblood! Good Gross and Net Margins should translate into good cash flow but sometimes late payments and other expenses can get in the way. So look at your Margins but prioritize Cash Flow, it provides a better gauge on the health of your company.
3 Areas Where Financial Statements Let You Down
Financial Statements have developed over time to help companies and investors but they are not perfect. Keep these shortcomings in mind when you use your financial statements.
1. Timing
Financial Statements show a snapshot at the end of a period and even if this period is just a month, it causes two problems. First, you have to wait up to a whole month to see how your company is performing. Second, when you finally get your financial statements, the information may already be out of date – your company is dynamic and may have already moved on. In both cases, this makes decision making difficult.
2. Financial vs Operational Focus
Financial Statements focus on financial results like sales, revenue, and liabilities. It does not focus on operations. For example, financial statements do not show you the utilisation of your team capacity or help you with staff turnover or the management of clients.
Eventually, an operational problem may manifest itself in your financial statements but then it may be too late or it may be difficult to see and disentangle other effects. As a company, you need to use operational metrics alongside your financial metrics.
3. No Forward-Looking Metrics
Financial Statements look at what has happened, not what is going to happen. Metrics like CAC and LTV help you make decisions today while looking to the future. But these and other similar metrics are not provided by Financial Statements.
Next Steps
This is Financial Statements 101. Once you have been to the doctor and understand the basic reports, it is time to take your company’s health to the next level. Setting specific targets for the key numbers, and translating these statements into visual reports are the next step to really bring more insights to you and help you make better decisions.
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