How Understanding Your Business Finances Helps You Understand Your Story
Nick’s parents immigrated to Australia from Greece with nothing, not understanding a word of English, but managed to build something for their family. Nick was the first generation to be born in Australia so he had all the benefits of being able to learn English at school to try to teach his parents while, at the same time, being able to speak Greek. As we grow older we can appreciate someone who is able to speak multiple languages. Nick was fortunate enough to be one of those people.
He always joked that if he wanted to share a story with one of his siblings, who also spoke English, but keep it from his parents, they spoke English. So Nick was familiar with sharing stories which others might not understand. He probably did the same thing by speaking to his parents in Greek in later years so his own family wouldn’t know what they were talking about.
When training people to understand their business finances, I like to share a story to make a problem or challenge in business seem less boring or to simplify a potentially complex theme.
Nick’s challenge was that he didn’t understand the story of his business and, more specifically, he didn’t know how to read his business finances. I explained to him that he had to understand the financials to know the story of his business!
Nick had worked incredibly hard to build a successful trade business and I knew he had made investments in property. Therefore, I knew he understood the concepts of debt and investing in property, which is not too dissimilar to the financials of a business.
Understanding Your Business Finances
The story of your business is the Balance Sheet (sometimes referred to as the Statement of Financial Position) and the Profit and Loss (also referred to as the Statement of Financial Performance).
Financial statements can be very confusing by presenting a huge array of numbers and phrases in the hope that the person reading them understands what is being put in front of them.
Me: “Nick, think of a rental property that you own. The concepts of your relationship with a rental property are really no different than understanding the financials (and story) of your business.”
Nick: “Ok, talk me through it”
Me: “Let’s start with your business’s balance sheet, which lists the assets, liabilities and your equity of your business. This is exactly like the rental property you own.”
Nick: “How so?”
I walked to the whiteboard and started drawing.
Me: “Your rental property is broken up into three core areas: first there is the property itself or the house. Let’s say that it is worth $500,000. This is the asset. So the house is like the first part of your business balance sheet. This will list everything your business owns like cash, people who owe your business money, the plant and equipment, and motor vehicles.”
I continued (I don’t need a second invitation).
Me: “Then you have the money that you still owe to the bank for the mortgage on the property. Let’s say we have $300,000 owing on the property’s mortgage. This is the second section of your balance sheet: the liabilities, everything your business owes such as tax payments, employee entitlement, suppliers costs, finance contracts and bank loans.”
Then I threw him a question to see if he was still awake.
Me: “When you have a $200,000 difference between assets and liabilities with the assets being higher, what is this called?”
Nick: “The equity.”
Me: “Spot on. Equity is your entitlement to the difference. If you have a business with assets of $500,000 and liabilities of $300,000, and you were to sell the assets and pay the liabilities, you should end up with $200,000 in your pocket. That would be your equity – exactly the same as a balance sheet of your business. That is all your balance sheet is: what your business owns, less what it owes, and the difference is yours. The only difference between this and your rental property is that there are generally a lot more line items!”
This then leaves the easy part: the Profit and Loss statement.
Me: “The Profit and Loss is the part of the story people look to first, which is fair enough because it shows you how the business has performed over a period of time. However, the balance sheet shows what a business has in its possession. One is more important than the other, but you are only getting half of the story if you aren’t including the balance sheet.”
Nick: “The P&L is just what my income is less my expenses”.
Me: “Exactly, the income is primarily what your client pays for your business’s product or services and the expenses are the costs associated with providing those products or services. This can include materials, labour, and overhead like rent and electricity”.
That is the story of your business and how to understand it. Don’t get caught up in the complexity of your business finances – the numbers and the words. Just ask yourself, “Is it something I own or owe? And is it money coming in or expenses going out?” If you know that, then you will truly know the story of your business.