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As an immigrant, you may wish to venture into entrepreneurship by starting your own business. While this is an exciting time in your life, there are many aspects of business that you should understand before jumping in. Being self-employed comes with many responsibilities and daily functions.
One of the most important functions in your new business is keeping your financial statements current and readily accessible. You will use them to manage your income and expenses, while analyzing your improvement areas, managing cash flow and tracking profits.
After reading this article, you will understand what financial statements are and how you can use them to analyze your business operations. You will know what classifies as assets versus liabilities and the different types of financial ratios that can be calculated from the data in your financial statements.
Hopefully you’re earning profit! You will also learn how to analyze your own finances after giving yourself a paycheck.
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What are Financial Statements?
Financial statements are a compilation of the financial activities in your business. This data is used to illustrate the financial performance of your company and to make predictions about the future success. The financial statements can be used for tax, financing, and investing purposes.
The most basic financial statements are: balance sheets, income statements, cash flow statements, and statements of shareholders’ equity.
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What are the Main Types of Financial Statements?
There are many different types of financial statements to know. However, here are the two main ones to understand along with what encompasses them. They will help you to comprehend the overall health of your business so you can continue growing. When one financial statement changes, it affects the other.
Statement of Financial Position
A statement of financial position is also called a balance sheet or net worth statement. It gives you a snapshot of your net worth at any given time.
This financial statement should include details about your assets and liabilities, as well as any ownership of property, at fair market value.
Assets are resources that hold monetary value for you personally or for your business. You can consider them to be items that can bring you some type of cash flow in the future. That could be actual money, or something like equipment or a patent that can improve your business operations.
On the balance sheet, your assets should be listed in order of liquidity. This means that the asset you can obtain usable money from the soonest should be listed first. For example: Cash and cash equivalents, investments, and personal use assets.
Liabilities are considered to be debts or obligations that a company or individual owes to someone else. They can be acquired through the transfer of money, goods, or services. A few examples include loans, accounts payable, mortgages, and accrued expenses.
On the balance sheet, your liabilities should be listed in accordance with their due date. This means that the liability you need to pay for first should be at the top. For example: Current liabilities (due in less than a year), and Long-term liabilities (due in one year or more).
Statement of Cash Flow
A statement of cash flows, or cash flow statement, calculates the number of cash inflows minus cash outflows to give you net cash flow. Unlike a balance sheet, this statement covers a particular period of time.
The financial statement should include details about your income and expenses when necessary. It should be analyzed on a monthly basis, and each expense should be calculated as a percentage of total income.
Cash inflows represent the money coming into your business. This could result from sales, investments, or financing. The goal is for your cash inflow to be greater than your cash outflow.
A few examples of cash inflows include:
- Gross salaries
- Interest and dividend income
- Gross rental revenue
- Tax refunds due
- Realized capital gains
- Alimony or child support received
- Trust income
Cash outflows represent money leaving a business. This could result from operating activities such as payments to employees, manufacturers, or suppliers, as well as money being used for investing purposes.
A couple examples of cash outflows include:
- Savings and investments
- Non-discretionary (voluntary spending) fixed and variable expenses
- Discretionary (required spending) fixed and variable expenses
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How Can I Apply the Financial Statements to My Finances?
Now that you’ve analyzed your business and earned a paycheck, it’s time to put your hard-earned money to good use. After paying all of your bills, use the funds to further your personal financial position. You can do this by paying off debt, building an emergency fund, or investing for retirement.
Use these four ratios to get a better picture of how you are managing your money. You’ll have specific actionable data to use to drive your improvements, and it will be easy to track your progress moving forward.
Use a current ratio to assess your ability to meet short-term obligations. You’ll divide your current assets by your current liabilities to find your current ratio.
Current assets consist of cash, cash equivalents, accounts receivable, and inventory. Current liabilities consist of accounts payable, current debts, and taxes.
An appropriate target is for this ratio to stay between 1.0-2.0. However, a ratio higher is preferable because it indicates that you can pay off existing liabilities with your liquid assets.
Consumer Debt Ratio
Next you’ll want to analyze your consumer debt ratio. To calculate this, divide your non-housing monthly debt payments by your monthly net income. (To find your monthly net income, you’ll need to subtract your monthly taxes from your monthly gross income first).
This ratio gives you a strong idea of if you have too much debt. An appropriate target is for this ratio not to exceed 20%. If you have 10% or less, you are borrowing wisely. However, if you are exceeding 20%, you should rethink your spending and come up with a strategy to eliminate some or all of the debt.
Housing Cost Ratios
To find your housing cost ratio, divide your monthly non-discretionary housing costs by your monthly gross income. You should not be spending more than 28% on your housing expenses. If you are, you may want to consider moving to a more cost effective living situation.
Additionally, you can calculate your debt-to-income ratio by dividing all your monthly debt payments and housing costs by your gross monthly income. You should have a result of less than or equal to 36%. If your percentage is higher than that, you have taken out too much debt in comparison to how much you make. As mentioned earlier, you will want to start paying off the debt to put yourself in a less risky situation.
TIP: These are two common ratios calculated by mortgage lenders. They are strictly followed to ensure homebuyers are taking out reasonable mortgages in comparison to their income and debt payments.
This ratio is exciting to calculate and track! You’ll divide your total savings per year by your gross income to obtain your savings ratio.
Unlike the other ratios discussed, this one does not have a targeted goal. It will depend on your age and financial goals. Typically, the older you are, the higher you should aim this ratio to be.
However, the more you save, the better off you will be. Aim to increase your savings ratio regularly and track it as time goes on. Having a high savings rate can help you with an emergency fund, retirement savings, and education planning.
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Look at Your Business and Personal Finances Today
It is important to use tools like financial statements and ratios to consolidate the data so you can have it readily available for business functions like tax audits and projections. Additionally, you can use them to monitor your profits over specific time periods.
No business owner or individual will have financial success without tracking their income, expenses, debt, and savings. Whether you’re using these tools for business or personal purposes, they can help you set goals to improve your financial future and track your progress as time goes on.