As a business owner, you know that your financial statements are not only a reflection of your organization’s financial health. They’re also tools you can use to make better financial decisions to grow your business.
In order to understand your company’s financial situation, you’ll need to know about 3 key financial statements:
- Balance sheets, which show a company’s assets, liabilities and net worth on a stated date;
- Income statements, which show the net income of the company over a stated period; and
- Cash flow statements, which show the inflow and outflow of cash caused by the company’s activities during a stated period.
Here’s a quick crash course on Financial Statements 101.
What is a Balance Sheet?
A balance sheet is essentially a photograph of your finances on one particular date. It gives an overview of assets (anything of value), and who owns these assets: someone else (liabilities) or the business owner (the owner’s or stockholders’ equity).
ASSETS = LIABILITIES + OWNER’S EQUITY
A balance sheet is always separated with assets on one side, and liabilities and owner’s equity on the other side. These sides must always balance (hence the name).
What is an Income Statement?
Also known as a profit and loss statement, an income statement reports a company’s financial performance over a specific period. Or, in short, it reports how much revenue your company earned, minus the costs and expenses associated with earning that revenue. The final line of your income statement will reflect the company’s net profit or loss incurred. The typical formula for an income statement looks like this:
SALES – COSTS = PROFIT OR LOSS
Unlike balance sheets, income statements cover a range of time, the most common periods of time being annual financial statements and quarterly financial statements. Your income statement provides a full overview of revenue, expenses, net income and earnings per share. When you look at your past 2-3 years of data, you’re able to compare trends and better understand how you’ve grown.
The net income for the year will flow into “retained earnings” which is part of the equity section of the balance sheet. The retained earnings number will be impacted by any dividends that are paid out to shareholders.
What is a Cash Flow Statement?
A cash flow statement is a detailed and dynamic listing of transactions of the money flowing in and out of your business. Your cash flow statement details where your money is coming from each month (inflowing sources), and where your money is going (outflowing sources).
Ultimately, a cash flow statement reconciles your income statement with your balance sheet in 3 major business activities: your core operating costs, investing and financing activities.
Operating Cash Flows
The net operating cash flows reflect how much cash is generated by your company’s products or services, minus how much cash it costs to operate your company. Cash inflow would include cash collected from sales, for example. Cash outflows would consist of payments on accounts payable and salaries, for instance.
While accounts payable on the balance sheet shows the quantum of amounts owing to vendors, the cash flow statement will show the cash flow impact of the changes to accounts payable on the balance sheet. The same logic applies for other balance sheet accounts like accounts receivable. For instance, if you’re looking at a monthly cash flow statement, an increase in accounts receivable by $5,000 on your balance sheet from the prior month will effectively result in a decrease of cash of $5,000 on your cash flow statement for the month.
If your business has any changes in assets, equipment or investments, they’ll be listed here. Most investing activities are considered “cash out”. For example, if you’re purchasing new equipment or renovating a new retail space, the money spent will be considered cash out. However, if you’re divesting of an asset—for example, selling a building or excess inventory—the transaction will be considered cash in.
If your business has any changes in debt, loans or dividends, they’ll be listed here. Financing activities are considered “cash in” when capital has been raised, and “cash out” when principal on an asset is paid down.
How Can I Use My Financial Statements?
Analyzing the history of your financial statements with a professional bookkeeper can help you better understand where your money is going, allowing you to budget more sensibly. You’re able to foresee financial problems before they happen, as well as spot opportunities for growth.
A strong income statement and cash flow projection will be critical for securing new financing or for attracting new investors. Your projections are much more credible if they are based on historical trends with reasonable assumptions about changes to the business environment. It’s important to understand that while your financial statements tell a story of how the business has performed in the past, the data can be used to generate projections of how the business will do in the future.