Although the above business is making a positive net profit, the actual money is flowing out faster than it is flowing in. This business would find itself in a cash flow squeeze very quickly.
Return on investment
Return on investment (ROI) is the amount of net profit the business makes, shown as a percentage of how much money the stakeholders have invested in the business. Remember that the stakeholder is usually the owner/manager.
For example, let’s assume that when you started your business, you made an initial cash investment of $50,000 and you have not had to invest any further funds in the business. You could have taken that $50,000 and put it in an investment certificate yielding 5 percent. If you had done that instead, you would have made $2,500 every year:
$2,500 ÷ $50,000 = 0.05 = 5%
Your return on investment on the investment certificate then would be 5 percent.
However, you didn’t invest in the certificate, you invested in your business. So how do we look at the roi on your business? In exactly the same way. You’ve invested $50,000. Your business generates $7,550 in net profit annually. Your roi is:
$7,550 ÷ $50,000 = 0.15 = 15%
Therefore, the same $50,000 would generate an roi of 15 percent when invested in your business versus 5 percent in an investment certificate. This is a useful way of evaluating your investment in the business and seeing how your investment return changes from year to year. We will discuss investment return in more detail in Chapter 12.
Let’s move on to Chapter 1 and take a quick refresher course on the reports that make up your financial statements.
1
Refresher: Balance Sheet, Income Statement, and Cash Flow Statement
In this chapter, you will learn –
• The basic attributes of the balance sheet, income statement, and cash flow statement
• How the three statements interconnect
• The difference between net income and cash flow
Before we can examine how to interpret your financial information and make valid management decisions based on that information, you need to understand the three basic financial statements of the business and how they work. If, after reading this chapter, you feel that you need to brush up on bookkeeping topics, please refer to Bookkeepers’ Boot Camp, the first book in the Self-Counsel Press Numbers 101 for Small Business series. There you will learn the basics of double-entry bookkeeping and how to prepare your financial statements.
The three basic financial statements for any small business are the —
• balance sheet,
• income statement (sometimes called the profit and loss statement or P&L), and
• cash flow statement (sometimes called the statement of changes in financial position).
We will look at each of these in turn.
The Balance Sheet
The balance sheet is a freeze-frame picture of the assets a business owns and the liabilities (debts) a business owes at a particular time. Sample 1 shows a typical balance sheet.
Sample 1: Typical Balance Sheet
For example, if a business prepared a balance sheet as of December 31, it would show some or all of the following assets:
• Cash in the bank
• Accounts receivable (i.e., amounts to be received from customers)
• Inventory
• Capital assets (e.g., equipment)
And the following liabilities (debts):
• Suppliers that will be paid in the future
• Bank loans and mortgages
• Wages payable to employees
The liabilities are split on the balance sheet between current (those that will be paid within one year) and long term.
The balance sheet also shows the owner’s equity. This is the sum of —
• retained earnings (i.e., all the historical profits a business has made that have been left in the business),
• capital stock (i.e., the stock that has been purchased by shareholders in a corporation), and
• contributed capital (i.e., any capital funds that have been invested by the owners of the business).
In other words, the owner’s equity is the net worth of the business. Another way of valuing net worth is to subtract what the business owes (liabilities) from what the business owns (assets).
Assets – Liabilities = Owner’s equity
or
Assets = Liabilities + Owner’s equity
One final note to keep in mind about the balance sheet is its valuation. In most countries, accounting rules (called Generally Accepted Accounting Principles or GAAP) require that the balance sheet be valued at historical cost. That means, for example, that if your business bought the building in which it resides in 1982 for $100,000 and it’s now worth $295,000, it will still be recorded in the balance sheet at its historical cost of $100,000 (minus depreciation). For this reason, a balance sheet does not always give a business owner the true picture of the value of a business. We will discuss valuation principles in later chapters.
The Income Statement
The income statement shows the revenue and expense activities of the business for a period of time — be it a day, week, month, or year. See Sample 2 for an example of an income statement.
Sample 2: Income Statement
