In the first of this two part series, we discussed several of the basic concepts behind understanding small business finances. Among others, we explained budgeting and how to create one, the necessities of good bookkeeping, and the importance of having positive cash flow. In the second part of this article, we will address profit and loss statements, business financing and capital formation.
Let’s start with the profit and loss (P&L) statement. Perhaps the most important financial management report is the P&L statement. A P&L statement will reflect your business decisions on the basic buying and selling process. A P&L will tell you how well you are managing your business and provide information on how to grow your business. The P&L statement is the best tool for knowing if your business is profitable. A P&L statement measures revenue, also called sales or income, and expenses over a month, quarter or year. With it you know if you have made a profit, and how much, or if you have incurred a loss. The basic formula to calculate this is as follows:
Less: Cost of Goods Sold (variable costs)
Equals Gross Profit
Less Overhead (fixed costs)
Equals Net Profit/Loss
Here is a brief description of what each component in the above formula represents.
Sales: Total amount from selling your product or service during a certain time period.
Cost of Goods Sold: Total expenditure for inventory items which customers buy. Cost of Goods Sold consists of the cost of purchasing the items, freight, manufacturing costs, modification costs, and packaging. For services, this is the cost of providing the services, including labor, material used, and transportation.
Gross Profit: Sales less Cost of Goods Sold.
Overhead: Expenses associated with your ongoing business operation, such as rent or utilities.
Net Profit: Gross Profit less Overhead. Net Profit is what remains to pay for expansion, equipment, loan repayment, income taxes and owner’s draw.
Business financing is essentially how you decide to capitalize on your enterprise. In general terms, there are two methods. One is equity and the other is debt. It’s that simple. The decision on how to capitalize depends on a number of things, most importantly how much money you have to put into the company.
Your cash flow statement that we spoke of in the first part of this series will tell you how much cash you need on a monthly basis to keep the doors open. You need to have at least six months of cash flow on hand whether it is sourced through debt or equity. With equity financing, invested funds generally stay in the business, often permanently. For most small businesses, equity comes from the owner or from family savings and is frequently the only source of funds for start-up small businesses. For large, fast-growing quality companies, venture capital can sometimes be accessed for equity.
Remember that if you are using someone else’s money, you will be giving up a portion of your business. This is the banter that you will typically see on TV’s Shark Tank series. The give and take are almost always over what the business is worth now (present value) and what the business will be worth in the future. As such, the more money you need in the form of equity, the greater the percentage of ownership (stock) you will be giving up. Mark Cuban would always say only use someone else’s money if you really need it to grow.