Your business’s financial statements are your best indication of its current financial health and your most effective tool for making critical business decisions. At a minimum, you need to know if your business is making a profit or losing money, but your also need to be able to calculate your business’s current and future financial needs.
What the Balance Sheet Tells You
The balance sheet is a snapshot of the health of your business at any given time. It tells what you own (assets), what you owe (liabilities) and what’s left over (net value). It is only a snapshot, because the numbers change with every business transaction.
Assets: Current assets are everything the business can get its hands on in order of liquidity, including cash, inventory and receivables. Non-current assets include furniture, equipment and property.
Liabilities: The balance sheet indicates which liabilities are current (short-term debt) and non-current (long-term debt), listed in the order they need to be repaid.
Net worth: Assets minus liabilities equals a business’s net worth. This includes any invested capital along with retained profits.
Current ratio: The current assets divided by the current liabilities, indicating whether your business has enough liquid assets on hand to pay bills in the short term. A ratio of 1.5 or higher is usually sufficient, depending on the type of business. A ratio of less than 1 indicates that your business may be in danger of not meeting short-term obligations.
Quick ratio: The difference between current assets and inventories, divided by the current liabilities. The [quick ratio][https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/financial-ratios-4-ways-assess-business.aspx) removes the inventory from the current ratio equation for a more conservative view. A quick ratio above 1 is generally regarded as safe.
Working capital: The difference between current assets and current liabilities; generally, a positive working capital ratio is better.
Debt-to-equity ratio: Total liabilities divided by shareholders equity, telling you how much your business relies on debt for its operations. A lower ratio is viewed more favorably.
What the Income Statement Tells You
The income statement tells you how your business is doing within a specified period of time and how much money is available to pay debt and grow the business.
Gross profit margin: The difference between revenue and cost of goods sold, divided by the revenue. Your gross profit margin is an indicator of how well you are pricing your products.
Net profit: The difference between total revenue and total expenses, making it the most important indicator of your business’s financial health. It is the cash that shows up on the bottom line each month after you have paid the bills.
Net profit margin: The net profit divided by total revenue, converting your net profit into a ratio that you can use to identify important trends in your business. The net profit margin tells you what percentage of your revenue is profit. If your sales revenue for the month totaled $20,000, and your expenses (rent, payroll, production, etc.), totaled $13,000, your net profit margin is 35 percent. Using your net profit margin, you can identify trends and project future profits.