Something that many people don’t realize and most people never think about is the fact that your financial statements are mostly just opinions. It’s true of both your balance sheet and your income statement. If you're shaking you head right now saying “no way,” then let’s talk it through.
The Only Three Facts On Your Financials
There are only three facts on your financial statements. One is cash, another is debt, and the last one is expenses. That may seem like a grim point of view but it's true. Cash is an indisputable asset that will be worth the same amount (in the same currency) regardless of what else changes on your balance sheet. The same is true of debt. The amount of money you owe doesn’t change with the markets or economic conditions. Expenses are typically historical records of what you’ve paid out so they are facts as well.
Let's Start with the Balance Sheet
Your balance sheet is the document that lists the value of all your assets and liabilities. People can get pretty defensive when talking about balance sheets because that’s the one that has a line for “net worth.” First, let me say that no one's actual worth can be defined on a piece of paper. However, from a financial perspective, this is where we calculate the difference between the listed value for assets and liabilities. As you are about to see, most of what you have listed on your balance sheet is actually opinion and not fact.
Assets are the things that we have invested in to make us money. They are the things that we own. However, despite what your balance sheet says, the value of those assets is fluid and only truly definable when we sell those assets. For instance, you may have a building listed as an asset with a value of one million dollars. That typically means that you bought the building for a certain amount, have depreciated it a certain amount and the result is the one million dollar value. However, when you get ready to sell it, you’re going to have an appraisal done. If the appraisal comes back at $1.5 million, you aren’t going to tell your realtor “no the balance sheet says $1 million so that’s all we’re going to ask.” You’re going to set the price at $1.5 million or higher because you want to get all the value you can from it.
At the same time, if you have to sell the building and the best offer you get is $800,000, then that is the actual value of the building at that time because that is what someone will pay for it in that market. The value of our assets is fluid and constantly changing. I’m not saying you should adjust those values non-stop. That would be a futile endeavor but you should be aware that asset values are opinions and not facts.
Liabilities are typically facts. The amount you owe banks, investors or other lenders doesn’t typically change with the markets. You will have to pay the amount you agreed to pay, whether its for inventory, real estate or an operating loan. Regardless of the changes in value of the thing you used the money for, your debt is a constant that you are required to pay off. There are a few exceptions where the liability is dependent on changing market values like in the case of a stock repurchase program. Sometimes, when stock is being repurchased over time, the company will repurchase that stock at the current market value which changes over time. However, this is pretty rare and most companies will never see this kind of debt on their balance sheet.
Because your net worth is dependent on the value of your assets, your net worth is also an opinion and a fluid representation of what your net worth might be. Don’t get me wrong, higher is still better and it’s still an important number but be aware that it’s not a guarantee of anything.
Your Income Statement
This is where a lot of arguments can start. People think that profit is a fact. It sometimes is but it’s usually not. “But how can profit change?” you may be asking. There are a couple of different ways. One is if you are in the business of trading for used inventory like we are. If that’s the case, the actual profit you made on any one deal or product line or brand (depending on how you record it) is never definite until you’ve completely washed the deal out. When I say that, what I mean is that because the value of used inventory is just an opinion until it gets sold, you never know what you’re actually going to make until you’ve sold all the trade ins on all subsequent deals.
For instance, if you sell a machine for $100k and trade for one you think is worth $50k, you will record a gross margin on the first product right then. However, if you end up selling that trade in for $40k, your actual profit is $10k less than you originally thought it was. The same line of thinking holds true if you took another trade in on that machine that you think is worth $30k but eventually sells for $25k. Your profit, even though already recorded, is actually just an opinion whose real value moves when the market tells you what it’s willing to pay.
If you really want to “get real,” the same thing is true of your new inventory. Just because you’re not willing to sell it for less than a certain amount, doesn’t make it worth that amount. The value moves up and down with demand and supply but that’s really more of a balance sheet issue than income statement.
Expenses are typically a fact on your financials because they are a history of money you’ve already spent, however, in an accrual system, even expenses are really just opinion until the cash actually leaves your bank account. This is why the most important measure of a business is actually the one that most people tend to ignore.
The Most Important Measurement in a Business
The most important measurement in a business, the one that will determine whether most businesses thrive or die is one that is full of facts. That measurement is cash flow. Cash flow is a factual measurement that records what actually happened in your business as far as cash coming in and cash going out. If you have more cash going out than you have coming in, you will eventually run out of cash. That is a fact. That fact has no regard for how profitable you show to be on your income statement. It has no regard for how much net worth you show on your balance sheet. Profitable businesses run out of cash everyday. Businesses with a high net worth run out of cash every day. Know your cash flow. Believe in your cash flow.