This YouTube interview (Richard Canfield with guest Henry) explains common gaps business owners and some financial professionals have when reading financial statements. Henry emphasizes empowering owners with the language of financial statements, highlights that standard reporting includes four statements (balance sheet, income statement, cash flow statement, statement of equity) but small-business clients often receive only the balance sheet and income statement. He walks through balance-sheet interpretation (snapshot date, reported cost vs fair market value, financing of fixed assets) and stresses the importance of the balance sheet. He also notes that income-statement items like amortization/depreciation are non-cash and can mislead owners who equate net income with cash available; Henry points to the cash flow statement as commonly-missed but informative.
Chapters
Foreign.
What are some of the other common things that you tend to find or, or we'll call them gaps that you see in the meetings that you have with an individual. Once you get a chance to unpack the financial statements, go through a bit of a questioning process. What would you say are some of the top gaps that you tend to recognize? And obviously it's very varied. Everyone has different business structures. But, uh, what are things that come up for you just off the top of your head that you tend to see happening for the business owners that you serve?
Yeah. And so what I want to focus on is actually empowering the language around financial statements. And I'll go through just an example of them and then just kind of what to see and interpret. Again, it's not going to be applied unilaterally, but the biggest gap is, I mean there's, there's layers to this, which is, there's financial statements, which is what you're going to see, and financial and analysis at that level, and then there's operational financial analysis, which is going to be specific to your business model, specific to your processes, specific to your actions and what you would take related to that. So I will give some examples using a traditional business model. And you know, I'm kind of deriving the information from client of mine, but nonetheless it's to illustrate, kind of using the context of the information here, how you're looking at the financial statements as a business owner from your lens of view. And then, then you can kind of kind of move forward from that. So the first thing I just kind of want to set out is financial statements. There's officially four pages, let's say, of them. There's the balance sheet, there's the income statement or statement of profit and loss, there's a cash flow statement, and then there's a statement of equity. Now in the, let's just call it in the business owner, small business owner world, depending on what your kind of services you're getting, they usually only give you two of those financial statements, which is the balance sheet and the income statement. And unfortunately, and I'm going to share this in our example today, that there's a lot of information you can get from the cash flow statement that is unfortunately missed. And I wanted to use that as some teaching points for the listeners to go through. So I want to first share my screen and show an example of a financial statement and actually go through the interpretation of it just to again set the stage of understanding. So what you see in front of you is a balance sheet. And on this balance sheet, the first thing to really understand at a high level on a surface standpoint is a balance sheet you're going to see is as at December 31, which is basically taking a snapshot of the corporation at that point in time. So if you have your professional prepare financial statements for you and a balance sheet as of January 31, February 28, those are going to show you snapshots of the business at that point in time. And the way that most people may connect and resonate with is the balance sheet is essentially a present version of the net worth of the business. So personally, you don't have a net worth statement that you're running every single day or even every year. But the benefit of actually a corporation is you have a financial statement and you actually can interpret what your business's net worth is at this point in time. Now the only drawback, and this is all in the sphere of the accounting world and it gets really confusing. So I'm not going to dive into it. But the elements in what you have, there's a discrepancy. It's the cost in what you pay for things and it's not the fair market value in what it is worth. So I'll use an example of where there's a discrepancy. Property plant and equipment, you could have paid $481,000 for it. You may be using depreciation mechanisms or CCA to bring down the value. So you could have bought the equipment for 500,000. And the cost of what that is is 481. But if you were to sell this equipment, then the equipment, if you actually sold it for what it's worth, and let's say it is worth quite a lot, it could be 1 million. Well, the financial statements are not going to write down $1 million because that's just not how they're structured. So there's a bit of a discrepancy when you're interpreting the financial statements. But that doesn't take away from, from actually still what you can see and the information you can glean on. So when you're looking at this $1 million in fixed assets, then you're. That's kind of one thing to take into perspective, that there's a difference from there. The other component to also look at as it relates to the financial statements and what I can tell, and I'm using just experience and how I would cut through the information is if I look at the property planning equipment, usually the structure of financing, you're not going to pay cash for it. Most of the behavioral attributes is they're going to go through with a financial intermediary like a bank to get a loan to pay for this financial sorry this property plan and equipment. So I can see right here, oh well they have some long term debt. It's no different than you having a personal residence home and it's a long term asset for you compared to you're going to you paid for 20% of it as a down payment. 80% of it is serviced through a mortgage or a long term loan. The financial statements reveal the exact same thing and it shows you all of the liabilities related to the business from a long term standpoint. So just kind of wanted to use that as an example to paint the picture of understanding the financial statements from a balance sheet standpoint. And I'm also going to place into position that the balance sheet is very, very important. It's your the business's net worth minus the fair market value adjustments between cost and fair market value. And unfortunately most financial professionals ignore the balance sheet. So this is very, very important to just capture to, for you to recognize related to it. To me, balance sheet is actually a very important statement.
Now one key thing I noticed about the balance sheet example that you just showed Henry, nowhere on it in the asset column was the business owner listed.
Absolutely.
So. So the most important component of the business, the person that is the visionary that runs the business, started the business, etc if they're not listed on the Ben on the I was in a, an event here recently. I believe this was maybe last week we did a, we did a webinar for business owners and we asked a question for people. What would happen to all the business owners on the call if all of a sudden you were no longer available to run the business? What would happen to the business? And the responses that came out in the chat box were consistent across the board that the business would go to zero, it'd be worthless, it would die, it would drift off, it would become less valuable. It was a whole host of these common elements. Now that's not the case for every business, but certainly it is the case for many of them. And in that scenario, what you just showed us, nowhere in the asset column was the business owner listed. Now how you would identify that is if you had cash surrender value of insurance and there was a value appropriated for that. And so we can then infer and investigate with some questions. Who's that insurance on and is that the business owner?
Absolutely. And you know, part of this is just maybe stemming from the lack of training. I mean, I have trained CPAs to get credentialed, to get their designation for over 12 years or so. And in that training process, I know in the curriculum, and I've been involved in that curriculum, there isn't a discussion on how do you account for and treat permanent life insurance. And the way that it needs to show up on the. Is to show up on the balance sheet as an asset. And unfortunately, because of that gap in knowledge, this is my opinion that when they see premiums coming out from a whole, a whole life insurance policy as an example, they think of it as an expense, but it's actually technically an asset on the balance sheet and it's represented. If the life insured is the business owner, which is the merits and the process that we go through to properly place it, the business owner is now being recognized on the balance sheet. This is, this is as an asset. This is a legitimate accounting entry that needs to show up on the balance sheet, not an expense out of the business. So, I mean, I'll go through the income statement next, but your, your property plan and equipment is on. The asset is on the asset list. Your accounts receivable, which I'll talk about next, later, is on the balance sheet. Your cash is on the balance sheet. But why is the business owner, who's just as vital to the business, who is an asset to the business, not on the balance sheet? Still, you know, the accounting is correct, but the thought process behind why it's not there is unfortunate. And this is a disservice to the business owner when they're not recognized on that balance sheet. So the next connection I want to lay out is the income statement. And this is what most people spend their attention on. And I kind of want to maybe clarify some concepts around the income statement. So what you will see is, as an example, for the year of 2023, this business, Canadian Hydraulics Inc. Has captured a set of activities that summarize the total of revenue of $3.4 million. So the gap that I want to highlight is amortization is actually not money going out of the business. This is an accounting method to equalize the cash flow. For when you buy equipment, a lot of money goes out, but it doesn't represent actually the value of the equipment to the business. And they're spreading. It's a methodology to spread that cost out over time. So when most business owners, or, sorry, when most financial professionals may be communicating to you as a business owner, like, oh, you brought in 143. But you as a business, you're in the business, you know very, very well. As an example, this amortization is non cash item. You actually brought in maybe even $200,000 as an example. $200,000. But that's because the issue with just looking at net income, you can get things clouded with the representation of how it's being presented. So I just want to highlight that just jumping straight to the net income number is not a good basis to form, formulate. Here's how much your business actually made. You actually need to look at the cash standpoint, because that's really how most business owners operate, how much cash you actually have in the bank. For us, we talk about cash value is much more important than cash. But we're kind of saying from a standard business standpoint. This is what I wanted to highlight here.
