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.
To fully comprehend your company’s financial position, there are 3 key financial statements you should know about:
- the Balance sheet, which shows your company’s assets, liabilities and net worth on a stated date,
- the Income statement, which shows the net income of your company over a stated period, and
- the Cash flow statement, which shows the inflow and outflow of cash resulting from your company’s activities during a stated period.
To help you understand and make the most of these numbers, here’s a quick crash course on Financial Statements 101.
What is a Balance Sheet?
A balance sheet is essentially a photograph of your company’s finances on a particular date. It provides an overview of what your business assets are, and who owns them: someone else, yourself, or your shareholders.
This is the balance sheet formula:
ASSETS = LIABILITIES + OWNER’S EQUITY
Assets are any items of value, and include:
- short term assets (like accounts receivable or inventory), and
- long term assets or fixed assets (like office equipment, buildings, or certain investments)
Liabilities are debts, and include:
- short term liabilities (like accounts payable or wages owing), and
- long term liabilities or long term debt (like business loans or mortgages)
Owner’s equity, or shareholders’ equity, is the amount belonging to you as a sole proprietor - or to your corporation’s stockholders - after liabilities have been subtracted from assets.
Balance sheets always show assets on one side, and liabilities and equity on the other - and the two sides must always balance (hence the name).
By comparing what your company owns, with what it owes, the balance sheet keeps you informed about your monetary situation so your business can avoid solvency issues.
What is an Income Statement?
Also known as a profit and loss statement, the income statement describes your company’s financial performance in terms of revenue and expense over a specific period. In short, it reports how much revenue your company earned, minus the costs and expenses associated with earning that revenue.
This is a typical income statement formula:
REVENUE - COSTS = PROFIT OR LOSS
While your gross revenue includes all income generated by your business – including sales of goods and services – your costs are broken out into:
- direct cost of goods sold/cost of sales (how much you paid to produce or provide your product or service), and
- indirect operating expenses (how much you paid for things like rent or advertising)
The amount arrived at after deducting cost of sales from gross revenue – and before deducting operating expenses – is called your gross profit.
Other line items on your income statement may include:
- customer returns,
- bad debts,
- asset depreciation,
- interest income or interest expense associated with investments or loans, and
- income tax
The final line of the income statement represents your company’s net profit (or loss) - also known as your net income. If you run a corporation, your net income flows into the “retained earnings” that form part of your shareholders’ equity.
Corporate income statements also include a calculation of Earnings per Share (EPS). This number reflects how much money stockholders would receive for each share they own were your business to distribute its net income for the period. Retained earnings, then, are impacted by dividends paid out to shareholders.
Remember, unlike balance sheets, income statements cover a range of time – most commonly 3 months (quarterly) or one year (annual).
Because they provide a full overview of revenue, expenses, net income, and EPS during that period, examining past data can help you compare trends and better understand how your business has grown.
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. The statement of cash flow details where your money is coming from each month (inflowing sources), and where it is going (outflowing sources).
What distinguishes cash flow statements from balance sheets and income statements is that they don’t accommodate future cash flow resulting from credit activities.
So, an increase of $5,000 in accounts receivable on your balance sheet over the prior month, for example, would result in a decrease of $5,000 in operating cash on your cash flow statement.
Ultimately, a cash flow statement reconciles your income statement with your balance sheet in 3 major areas: core operations, investing activities, and financing activities.
Cash Flow from Operations
Cash flow from operating activities refers specifically to money moving in and out of your company as a result of your normal business activities.
It provides an overview of how much money is flowing in as cash collected from sales, versus how much is flowing out as payments (to suppliers or employees, for example).
Cash Flow from Investing Activities
When your business experiences changes in its assets, equipment, or investments, these appear in the investing activity section of your cash flow statement.
Most investing activities are considered “cash out”. For example, if you purchase new equipment or renovate a retail space, the money spent will be considered cash outflow.
If you’re divesting of an asset, however - by selling a building or excess inventory, for example - the transaction will be considered “cash in”.
Cash Flow from Financing Activities
When your business experiences changes in its debts, loans, or dividends, these appear in the financing activity section of your cash flow statement.
The flow from financing activities is considered “cash in” when capital is 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 will help you better understand where your money is going, allowing you to budget more sensibly.
Reviewing your financial statements regularly will also make it easier to:
- foresee financial problems before they happen,
- spot opportunities for growth, and
- secure new financing or investors with a strong income statement and cash flow forecast
While your financial statements tell the story of your company’s past financial performance, the same data can be used to generate projections of how your business will perform in the future.
Because they’re based on historical trends and reasonable assumptions about changes in your business environment, these projections are considered quite credible.
Finally, understanding the numbers on your financial statements is vital for measuring your progress against other companies in your industry. And it is this kind of competitive analysis that can help ensure your business keeps moving forward.