Understanding Financial Statements: A Guide for Small Businesses and Non-Accountants

Navigating the world of financial statements can seem like deciphering a foreign language for non-accountants. Yet, understanding these financial tools is important for making informed decisions in business, investments, or personal finance. This guide aims to demystify financial statements, breaking them into their basic components and explaining their significance in straightforward terms.

What Are Financial Statements?

At their core, financial statements are formal records that convey the financial activities and condition of a business, entity, or individual. They offer a snapshot of financial health, performance, and the flow of money over a specific period. The most common financial statements include the Balance Sheet, Income Statement (or Profit and Loss Statement), and Cash Flow Statement. Together, these documents provide a comprehensive overview of financial standing.

Related: Income Statements for Small Business Owners

Related: Financial Statements: Understanding Your Numbers

First, A Word About Accrual Accounting

Most businesses benefit from using accrual accounting. Accrual accounting records revenues and expenses when they occur, regardless of when payment is received or made. This approach differs significantly from cash accounting, where transactions are recorded only when cash is exchanged.

For businesses that engage in long-term projects, accrual accounting allows for the recognition of revenue as the service is provided rather than when payment is received. This method aligns revenue with the associated work period and effort, offering a clearer view of profitability and performance during specific periods.

The Balance Sheet

The Balance Sheet is a financial statement presenting a company's assets, liabilities, and shareholders' equity at a specific time. The balance sheet is important for several reasons:

• Financial Health Assessment: This allows stakeholders to assess the company's liquidity, solvency, and financial flexibility.
• Risk and Return Analysis: Investors use the balance sheet to determine the level of risk and return of investing in the company.
• Credit Analysis: Creditors can evaluate the creditworthiness of the business and its ability to meet short-term obligations.
• Benchmarking and Trend Analysis: By comparing balance sheets over time, companies can track their financial progress and asset and debt management trends.

The balance sheet follows a simple equation:

Assets = Liabilities + Shareholders' Equity

• Assets are resources owned by a business that have economic value. They can be divided into current assets (cash or other assets that will be converted to cash within a year) and non-current assets (long-term investments, property, plant, and equipment).
• Liabilities represent the company's obligations—what it owes to others. Similar to assets, liabilities are categorized as current (due within one year) or non-current (due after one year).
• Shareholders' Equity is the residual interest in the assets of the entity after deducting liabilities. It includes investments made by the owners (share capital) and retained earnings (the portion of profits not distributed as dividends).

The Balance Sheet offers a detailed snapshot of a company's net worth at a given moment, providing insights into its financial stability and capacity to expand or withstand hard times.

The Income Statement

The Income Statement, or Profit and Loss Statement, shows a company's revenues, expenses, and profits or losses over a specific period. It essentially tells you how much money a company made (or lost) in its business operations. It is one of the core financial statements used by companies to provide a clear view of their financial performance over a specific period, typically a quarter or a year. It summarizes the revenues, costs, and expenses incurred during this period and helps in understanding how these elements result in the net profit or loss of the business. Here's a breakdown of the key components of an income statement:

• Revenue (or sales) represents the total income from normal business operations. It's the starting point of the Income Statement.
• Expenses include all costs incurred to generate the revenue. These can be divided into cost of goods sold (COGS) and operating and non-operating expenses.
• Net Income is the bottom line. It's what remains after all expenses are subtracted from revenue. A positive net income indicates a profit, while a negative figure shows a loss.

The Income Statement provides valuable information about a company's performance, efficiency, and profitability, helping stakeholders assess its earning potential.

The Cash Flow Statement

The Cash Flow Statement breaks down the flow of cash in and out of a business, offering insights into its liquidity and solvency. A cash flow statement is a cornerstone financial document that tracks the movement of cash in and out of a business over a specific period, typically a month, quarter or year. Unlike the income statement, which uses accrual accounting to record revenues and expenses when they are earned or incurred, the cash flow statement focuses solely on actual cash transactions. This statement is essential for understanding a company's sources and use of cash over time. The cash flow statement is divided into three main sections:

• Operating Activities: Cash received or spent as part of normal business operations, including the cash receipts from sales and cash payments for expenses. This section shows the cash generated or used in the business’s core operations. It begins with net income and then adjusts for non-cash items (like depreciation and amortization) and changes in working capital (like accounts receivable and payable). It reflects how much cash is being generated from the company's products or services.
• Investing Activities: Cash used for or generated from investments like purchasing or selling assets (e.g., property, plant, equipment) or securities. This part details the cash used in or generated from investment activities. This includes purchases or sales of long-term assets like property, plant, and equipment, as well as investments in securities. It indicates how much cash is being used for investments in the long-term health and growth of the company.
• Financing Activities: Cash received from or paid to investors and creditors, including dividends, sale or repurchase of shares, and debt repayment. This section shows the cash flow associated with funding the business. It includes transactions related to equity (like issuing shares or buybacks) and debt (like loans and bond issuances). It also covers dividend payments. This section reflects how the company raises capital and returns value to shareholders.

This statement is crucial for understanding how a company manages its cash, pays its obligations, and funds its operations and growth. The net total of these three sections reveals the net increase or decrease in cash for the period. The statement concludes with the total amount of cash and cash equivalents at the beginning and end of the period.

Accounts Receivable Listing

The accounts receivable listing is a detailed document used by organizations to manage and track the amounts owed by customers for goods or services rendered on credit. This listing is a crucial tool in the management of a company's receivables and plays a significant role in its cash flow management. Key elements of an accounts receivable listing include:

• Customer Information
• Invoice Details
• Amounts Owed
• Aging Schedule
• Total Amount Receivable
• Payment Terms

The importance of an accounts receivable listing lies in its role in effective cash flow management. Regularly reviewing this list allows a business to identify which receivables are overdue and take appropriate action, like sending reminders or initiating collection processes. This is important because the longer a receivable goes uncollected, the higher the risk of it turning into a bad debt, which could negatively impact the company's financial health.

Accounts Payable Listing

An accounts payable listing is a financial document used by businesses to manage and track the amounts they owe to suppliers for goods and services received on credit. This listing is a crucial component of a company's accounts payable management and plays a significant role in cash flow and financial health. Key features of an accounts payable listing include:

• Creditor Information
• Invoice Details
• Amounts Owed
• Aging Schedule
• Total Amount Payable
• Payment Terms

The accounts payable listing is important for several reasons:

Cash Flow Management: Regular review of the accounts payable listing allows a business to understand its upcoming cash requirements, enabling effective cash flow management.

Maintaining Supplier Relationships: Timely payment of invoices is crucial for maintaining good relationships with suppliers. The accounts payable listing helps ensure that payments are made according to agreed terms.

Avoiding Overdue Penalties: Businesses can avoid late payment fees and interest charges by keeping track of payment deadlines.

Budgeting and Financial Planning: Understanding upcoming payables is essential for budgeting and financial planning, ensuring that sufficient funds are available to meet these obligations.

Financial Reporting Accuracy: Accurate accounts payable listings are necessary for preparing accurate financial statements, particularly the balance sheet, which reflects the company's current liabilities.

The Two Financial Metrics Every SMB Should Pay Attention To

Gross Margin

Gross margin is a financial metric used to assess a company's financial health and operational efficiency. It represents the proportion of each dollar of revenue that the company retains as gross profit after accounting for the direct costs associated with producing its goods and services. Gross margin is expressed as a percentage and is a critical indicator of a company's profitability and pricing strategy.

Here's how to calculate gross margin:

Gross Margin = (Revenue−Cost of Goods Sold)/Revenue) × 100

Where:

• Revenue is the total income generated from sales of goods or services.
• Cost of Goods Sold (COGS) includes all the direct costs associated with producing goods or providing services, such as materials, labour directly involved in production, and manufacturing overhead.

Gross margin is important for several reasons:

1. Profitability Analysis: It helps in assessing how effectively a company is delivering its services and how profitable these are. It is very valuable in understanding the difference between one service line and another so that you can allocate staff accordingly. You’ll want to work closely with your bookkeeper to ensure service line expenses are recorded properly.
2. Pricing Strategy: Gross margin can reflect a company's pricing strategy and its ability to control production costs. A higher gross margin often indicates that a company can charge a premium for its products or services and/or manage its production costs efficiently.
3. Comparative Assessment: It allows for comparison with industry averages or competitors to assess competitive positioning and market dynamics.
4. Financial Planning: Companies use gross margin to make decisions about scaling production, entering new markets, or altering product lines.
5. Investor Insight: Investors look at gross margin to understand a company's underlying profitability and potential for sustainable growth.

Gross margin can be particularly insightful for businesses that primarily deliver services. It highlights the company's efficiency in managing the direct costs associated with services, such as professionals' salaries, expenses related to specific projects, and other direct costs. High gross margins can indicate effective cost management and a strong value proposition to clients. That said, until you hit ~$1M in revenues, you don’t need to get too granular with gross margin.

What Does A Good Gross Margin Look Like?

There is a fairly common and simplified rule of thumb around a good gross margin, which is “⅓ - ⅓ - ⅓.” This model divides costs and profits into three equal parts, each representing one-third of the revenue. Here's a breakdown:

One-Third for Direct Costs: The first third of the revenue covers direct costs. These would typically include costs directly related to service/product delivery, such as salaries of professionals, expenses directly incurred for projects, and other direct operational costs. We have seen some pressure in this area as labour costs are on the rise.

One-Third for Overhead Expenses: The second third is allocated to cover overhead or indirect costs. These costs are not directly tied to specific projects but are necessary for running the business. Examples include administrative expenses, rent, utilities, marketing, insurance, and salaries of support staff. Offsetting some of the increases in direct costs associated with labour increases, we are seeing fewer fixed costs thanks to improvements in technology and remote work, creating an opportunity to have your operating expenses fall below ⅓.

One-Third for Profit: The final third represents the profit margin. This is the portion of revenue left over after all the direct and indirect costs have been paid. In this model, aiming for a profit margin equal to one-third of the revenue is considered a healthy target for sustainable business operations.

Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) is a key financial metric that measures the average number of days it takes for a company to collect payments from its customers after a sale has been made. It's an indicator of the efficiency and effectiveness of a company's credit and collections processes. DSO is particularly important for businesses that extend credit to their customers.

The formula to calculate DSO is typically:

DSO = (Average Accounts Receivable/Total Credit Sales) × Number of Days

Where:

• Average Accounts Receivable is the average amount of money owed to the company by its customers during a given period.
• Total Credit Sales is the total amount of sales made on credit during that period.
• Number of Days is the number of days in the period being analyzed (usually a month or a year).

DSO is important for several reasons:

1. Cash Flow Management: DSO directly impacts a company's cash flow. A lower DSO means the company is collecting its receivables more quickly, leading to better cash flow. This is crucial for meeting operational expenses and investing in growth opportunities.
2. Credit Policy Assessment: DSO helps in evaluating the effectiveness of a company's credit policies. If DSO is high, it might indicate that the company's credit terms are too lenient or that it is not efficient in its collection efforts.
3. Liquidity Analysis: A lower DSO enhances a company's liquidity position, making it easier to handle short-term liabilities. High DSO can tie up capital in receivables, limiting available cash.
4. Customer Payment Behavior: DSO can provide insights into customer payment behaviours. A rising DSO might suggest that customers take longer to pay their invoices, which could indicate potential credit risk.
5. Benchmarking and Performance: Companies often use DSO for internal benchmarking and to compare their performance against industry standards. It can be a competitive indicator in industries where cash flow is critical.
6. Financial Health Indicator: Investors and analysts look at DSO as a measure of a company's operational and financial efficiency. Consistently high DSO might raise concerns about the quality of receivables and the risk of bad debts.

DSO is a very important metric for businesses as it provides insights into the efficiency of credit and collections activities.

Why Understanding Financial Statements Matters

For non-accountants, the ability to read financial statements is empowering. It enables entrepreneurs to gauge their business's health, investors to make informed decisions, and individuals to understand the financial strength of their employers or potential investments.

Financial statements are vital instruments that paint a clear picture of financial health, guide strategic planning, and drive growth. Understanding the importance of financial statements is crucial, as they not only measure past and present performance but also provide a roadmap for future success. Whether it's for assessing profitability, attracting investors, maintaining regulatory compliance, or gaining competitive advantage, financial statements are indispensable tools that encapsulate an SMB's economic reality, offering insights critical for steering the business toward long-term prosperity and stability.

Here are a few reasons why this understanding is vital:

• Informed Decision Making: Knowledge of financial statements helps make grounded decisions regarding investments, business strategies, and financial planning.
• Financial Health Assessment: They allow stakeholders to evaluate a company's stability, profitability, and growth prospects, influencing investment, employment, and business decisions.
• Communication and Transparency: Understanding these documents facilitates better communication with financial professionals, enhancing transparency and trust.
• Performance Measurement: Financial statements provide a quantitative measure of business performance. They detail revenues, expenses, and profitability, offering insights into the company's financial health.
• Decision Making and Strategy Development: By analyzing trends in income and expenditure, management can identify areas for growth or improvement, allocate resources more effectively, and strategize for the future.
• Confidence and Credibility: Trust and credibility are paramount for medium-sized businesses. Transparent and healthy financial statements can help build confidence among existing and potential investors.
• Compliance and Legal Requirements: These reports help to ensure that the business adheres to tax laws, financial regulations, and ethical standards.
• Internal Management and Operational Efficiency: Financial statements help management by providing a clear picture of an SMB's financial health. This includes understanding cash flows, managing debts, and assessing operational efficiency. By identifying which services or products are most profitable or where costs are highest, management can make informed decisions to optimize operations.
• Risk Management: Financial statements help identify and manage risks. For instance, a balance sheet showing a high level of debt may indicate financial risk, prompting a business to take corrective action.

Tips for Understanding Financial Statements

Understanding financial statements without an accounting background sometimes feels impossible. However, non-accountants can unlock these documents' valuable insights with the right approach. The key lies in knowing where to focus your attention and how to interpret the information presented. Here are practical tips designed specifically for non-accountants to aid in this journey.

• Start with the Big Picture: Before delving into the details, understand the overall financial health and performance trends.
• Look for Key Indicators: Focus on important metrics such as net income, cash flow, and equity changes.
• Use Comparative Analysis: To gauge performance and health, compare financial statements over different periods or against industry benchmarks.
• Seek Clarification: Don't hesitate to ask accountants or financial experts to explain terms or figures you don't understand.
• Practice Regularly: Like any skill, proficiency in reading financial statements comes with practice. Regular review and analysis will sharpen your understanding over time.

Simplified Financial Reporting Guidelines for Small Businesses and Non-Accountants

One in five businesses fail within the first year. By year five, approximately 50% close. The number one reason businesses fail is because they run out of capital. Nearly 40% of companies fail because they run out of cash or cannot secure additional capital.

To survive, small business owners must prioritize financial management, and part of that is financial reporting. This article tells all.

What is financial reporting?

Financial reporting involves documenting your financial activities and performance within set periods – such as a monthly or annual report. These reports help business owners organize their accounting data so that it's easy to see the company's financial status.

Examples include a statement of cash flow, retained earnings, income statements, and your balance sheet. The report you focus on will depend on your objective. For example, your earnings report will be critical for investors, while your income statement and balance sheet will be of primary interest during tax season. Staying organized and using the right software will help you automate this process to focus on the bigger picture – your company's growth.

The importance of maintaining organized records

Keeping organized records will help you in several ways, including the following:

• By maintaining detailed, organized records, you can identify income sources. This process will help you determine whether you should charge GST/HST.
• Keeping complete, organized records benefits you from greater tax savings. You could forget some of your expenses if you do not document transactions.
• If you are audited, organized records will simplify the process. If information is missing, auditors may use other methods to establish your income or GST/HST net tax – which could cost a lot of monetary and time-related resources.

Financial reporting keeps you informed about your business's financial position and value. It allows you to better determine business trends, prepare budgets more effectively, and communicate your company's financial health to investors.

Choosing suitable accounting software

Online accounting software and bookkeeping services make staying organized easier than ever. These tools help simplify the financial reporting process and keep your records organized for your accounting partner.

Here are some of the top accounting software options and ones that we have selected for the Enkel technology stack:

• QuickBooks Online is cloud-based accounting software that lets you keep all your financial information, including expenses, transactions, and invoices, in one place. Customize your reports to see your company's profitability, operating expenses, cost of goods, and other critical accounting numbers.
• Dext Prepare is an excellent tool for tracking and managing expenses. Eliminating manual data entry for invoices and receipts ensures a more accurate, detailed audit trail and a more streamlined experience.
• Payworks is an optimal solution to improve payroll management. This tool will ensure accurate payroll-related documentation if your business is growing and you have hired employees or contractors.

The best software for your business will depend on your needs and industry. Explore options for greater customization or invest in all-in-one solutions like Enkel, leveraging the top bookkeeping and accounting software packages.

Seeking professional assistance if needed

Accounting and bookkeeping software has advanced greatly, helping small business owners manage their financial reporting needs more efficiently. However, the ins and outs of business finances are still complex. There is a lot to consider, and what's best for one company isn't always what's best for another – especially for taxation purposes.

While many small business owners manage their bookkeeping, other priorities could result in neglected books and incomplete records. Eventually, these businesses seek help from a professional to better manage their cash, make realistic plans, and stay focused on running the business.

Complying with tax obligations

Tax obligations can be overwhelming, especially as your company grows.

Detailed records are critical whether you're dealing with income tax obligations, GST/HST obligations, CPP contributions, or all of the above. Use your chosen software to track the amount of tax you collect, the expenses that can be claimed as input tax credits (ITCs), and the tax you must remit. Again, talk to a professional if you're unsure about what your business is obligated to do this upcoming tax season or if you'd like assistance every step of the way.

Final Thoughts

Understanding financial statements is essential for anyone involved in making economic decisions, whether in business, investment, or personal finance. We can demystify these documents by breaking down the components of the Balance Sheet, Income Statement, and Cash Flow Statement. This knowledge empowers individuals to make informed decisions and promotes financial literacy and transparency in the economic world. Remember, reading and interpreting financial statements is a valuable skill, opening doors to better financial understanding and smarter decision-making.

Are you a Canadian business owner or nonprofit that needs bookkeeping and accounting support? If so, Enkel will help you automate and streamline workflows to increase efficiency. Thanks to a combined client-centric, technology-powered approach, custom solutions make Enkel different. If you want to partner with an experienced professional you can count on, contact us today.