Understanding Your Financial Statements
The primary purpose of any business is to add value to its customers and earn money. If you are a business owner, your key job responsibilities are revenue generation and managing cost. These objectives can only be assessed by recording and reporting information about the transactions of the business.
Perhaps you have so few transactions that you find it sufficient to track all of it in a spreadsheet. No matter how simple you think it should be, this method is most inefficient, as a spreadsheet will not provide financials nor is it useful to your CPA, bank institutions, or management for critical decision-making.
Perhaps you refer to your income statement and your bank account for the basics, but most businesses ignore the most powerful financial tools in the accounting arsenal: the balance sheet and the cash flow statement.
Combined with the income statement, these statements provide a comprehensive financial view of any business. That’s why they’re considered essential components of a business plan. But what role does each of these financial statements play and how do you interpret the data they produce?
Here’s an overview of the three key financial statements and how they can help you keep your finger on the pulse of your business’s fiscal position.
Income Statement / Profit and Loss
Think of the income statement as your business’ report card.
The Income Statement, also referred to as a Profit and Loss (P&L) statement will show how profitable your business is over specific period of time, and inform the business owner what steps may need to be taken to increase profitability. This statement reveals the profit or loss of a business by comparing the revenues earned to the expenses incurred within that time period. When revenue exceeds expenses, the business earns profit. If the expenses exceed revenue, a loss will be reported. When investors look at your business plan, they will use your income statement to assess the level of risk involved in extending credit or venture capital your way.
However, the other financial statements are not to be ignored. The income statement alone will not assess the business’ overall financial condition.
The Balance Sheet
Think of the balance sheet as a window into your business’s financial strength
The Balance Sheet is an investor’s preferred starting point for building a picture of your business’s fiscal health, stability, and liquidity. In a nutshell, the Balance Sheet summarizes key financial information on a given date (as opposed to the income statement, which shows profitability over a period of time), at the end of a specific time period.
The Balance Sheet lists the following:
- Business assets – “What do we have?” Not just what your business owns, but what it controls or what is in its possession, such as a financed vehicle, cash, and inventory.
- Liabilities – “What do we owe?” Your debts, including loans, outstanding credit card payments, etc.
- Owner’s equity – “What is left over for the owner(s)?” How much of the business’s assets do you still own once you’ve paid off all your liabilities?
The Balance Sheet “balances” these items through the most fundamental accounting equation:
Assets minus Liabilities = Net worth (owners’ equity).
The Balance Sheet is key to providing insight for the following:
- The net value of your small business, should you ever want to incorporate or sell your business
- Current and long term debt
- Asset management and your ability to turn an asset into cash
- Assess changes in cash, accounts payable/receivable, equity, inventory, and retained earnings from prior periods
It’s recommended that a professional help you set up and interpret your Balance Sheet, and walk you through fully understanding it at first. Examining the Balance Sheet can be intimidating, but don’t shy away from it—it’s an essential part of your business plan and an extremely helpful tool for running your business.
The Cash Flow Statement
Think of the Cash Flow Statement as the business’ comprehensive bank statement
Cash doesn’t always flow in at the same rate that it exits, so the business owner must use this tool to understand and manage cash flow, to see where cash is coming from and where it’s being spent. More businesses fail because of cash flow issues than for any other reason, so the Cash Flow Statement should be updated more regularly, such as daily, weekly, or monthly to assess the amount of cash at the beginning and end of a period as well as the entity’s liquidity and solvency.
In all entities, the following formula will calculate your ending cash balance:
Operational Costs + Asset Investments + Financing = Cash Balance
In addition to helping you gauge whether your business has enough money to cover its day-to-day activities, pay its bills on time, and maintain a positive cash flow, your cash flow statement also informs a number of other financial decisions, such as whether you need additional capital to fund seasonal fluctuations or purchase inventory to support a growth in sales.
For lending purposes, you’ll include the cash flow statement in your business plan to provide evidence to your bank that you can manage cash and have a plan for dealing with cash flow gaps when they arise.
The Bottom-Line Benefits to ACCURATE Financial Statements
Don’t miss out on the success that financial statements may lead you to:
- Self-assessment – Business managers are the first key user of financial statements. The financials reveal the performance of management itself. The results of each statement can be compared to the budget, compared between months, or to prior year numbers to assess growth and achievement.
- Book valuation – One key element of a balance sheet is the owners’ equity. This is an indicative value (book value) of the business. The business can be sold at this value.
- Necessary to get bank loan – Have you ever applied for a bank loan and you were rejected due to lack of proper financial records? Banks require financial statements to make decision about lending to businesses. They want to know about the financial health and sources of cash flow in addition to qualitative conditions.
- Decision-making tools – Information from financial statements can support the decision making function of any business. Decisions about a potential new investment will require proper planning and financial impact analysis.
All three financial statements are interrelated. You can’t have a full picture without all three. Viewing them holistically can help you make smart financial, investment, and management decisions for your business.
Of course, your financials are only useful if they’re accurate, so seek the help of a professional to make sure you’re producing accurate financials. Every detail in the transaction is important, and Profit Source Advanced Bookkeeping will help to guide you through the process of recording every transaction, and how they flow to the end result: The Income Statement, Balance Sheet, and Cash Flow Statement.
Article by Karen Todd,
Senior Financial Analyst ~ Accredited Business Advisor
Profit Source Advanced Bookkeeping