As an entrepreneur, learning the ins and outs of business accounting or finance is usually pretty low on the priority list. Especially when dealing with the myriad daily challenges of starting and running your own business.
But whether entrepreneurs do their own bookkeeping or hire a bookkeeper to handle tracking their financial records, having a basic understanding of both the Profit & Loss Statement and Balance Sheet is a “must learn” entrepreneurial skill.
To truly understand your business’ financial position, both financial statements need to be looked at together. Simply relying on your accountant or bookkeeper for interpretation is not a way to build your business.
Financial Mistake # 1: Profit and Loss Statement Tunnel Vision
All business owners want to make a profit, so they naturally obsess about their Profit & Loss Statement (P & L). Clearly, Revenue and Expenses are always top of mind with small business owners, but it’s only part of the financial picture.
You ignore your Balance Sheet at your peril.
OK, that sounds kind of dire. But the result of doing so can be serious.
Rarely have I met an entrepreneur who realizes that looking at only the P & L may lead them straight into a cash flow bind…until they are in one.
Business failures caused by serious cash flow problems are all too common. But understanding and properly managing Balance Sheet Assets and Liabilities can help prevent that.
Your Balance Sheet is where your “cash flow warning system” is located. And you can use simple financial ratios to keep an eye out for problems too.
Don’t get me wrong, you still need to focus on profitability, but Accounts Receivable, Accounts Payable, Loans, Inventory and Fixed Asset purchases all affect cash flow. And balances in those accounts show on the Balance Sheet, not on the P & L.
Knowing how to use that information and carefully managing those balances can help avoid some nasty financial surprises, so taking steps to learn how to read both statements is very important.
Financial Mistake #2: Not Understanding the Accounting Method in Use
Or worse yet, mixing them together, which I’ve seen multiple times. There is no way to manage cash flow or know your true bottom line unless you know how your business finances are being “booked” in accounting parlance.
There are two methods of accounting: the Accrual Method and the Cash Method.
They are very different from a financial reporting standpoint and depending on the type and size of your business, one may definitely be better than the other for you. This is something to discuss with your accountant when opening your business.
Generally, I prefer accrual under most circumstances but sometimes the cash method is preferred.