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

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

The Balance Sheet

The Balance Sheet is a financial statement presenting a company's assets, liabilities, and shareholders' equity at a specific time. It 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.

  • 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. It categorizes cash flow into three main activities:

  • Operating Activities: Cash received or spent as part of normal business operations, including the cash receipts from sales and cash payments for expenses.
  • Investing Activities: Cash used for or generated from investments like purchasing or selling assets (e.g., property, plant, equipment) or securities.
  • Financing Activities: Cash received from or paid to investors and creditors, including dividends, sale or repurchase of shares, and debt repayment.

This statement is crucial for understanding how a company manages its cash, pays its obligations, and funds its operations and growth.

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. 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.

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.

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