For many business owners, financial statements can be overwhelming. However, learning how to read financial statements is critical to understanding the health of your business.
A business financial statement tells you the state of your assets, liabilities and cash flow.
How to Read a Financial Statement
Your business financial statement is broken into three parts. As a whole, they tell you where business income came from, where it went and where it is now.
Parts of Small Business Financial Statements:
- Balance Sheet
- Income Statement
- Cash Flow Statement
While not technically part of the financial statement, business owners and managers also track performance against budget during the given reporting period. This helps measure how well you are doing against your plan and previous reporting periods. It’s a useful tool to make mid-course corrections and adjustments based on performance.
The Balance Sheet
The balance sheet is a snapshot of your business finances at a given point. Typically, it’s prepared at the end of the month, quarter and year. It will detail your company’s assets, liabilities and shareholder equity.
You will want to pay attention to the ratio between assets and liabilities. This ratio lets you know if you have enough equity and cash to pay off your current debts. If the ratio is less than 1, your company could have issues paying current liabilities.
Assets are either physical items owned by the company that have value, or cash. When calculating assets, the fair market value of items in their present condition is used.
Current Assets are items that are expected to be sold or converted into cash within the next 12 months. The current inventory of cars on the lot at an auto dealer or products on the shelves at a retail store are examples of Current Assets.
Non-current Assets are items that you don’t expect to be selling but have value. This might include office furniture, computers or phones.
The total of these three items shows the net value of your assets if the company sold everything it owned.
Liabilities are what you owe to others, including payments and debts.
Current Liabilities detail outstanding debt. For example, you may have a short-term small business loan or money you owe to subcontractors for work performed. These are debts due within the year.
Long-term liabilities are financial obligations that you owe but do not have to be paid in the next 12 months. These might be items such as the mortgage on your business property.
Shareholder equity represents the money that would be left if you had to sell off all of your assets and pay off all of your liabilities. Your small business financial statement excludes Capital Stock and Retained Earnings in calculating your shareholder equity.
Capital Stock represents the money you invested to start the business.
Retained Earnings are profits from previous years.
Small Business Financials Formula: The Balance Sheet
In calculating your balance sheet, this formula is helpful:
Assets = Liabilities + Shareholder Equity.
The Income Statement
Small business financial statements also report earnings and expenses to determine your net income or loss. This shows your profitability during the reporting period. That’s the bottom line most business owners want to know every month: Am I making money?
It’s important to track income statements over time to identify trends. Spotting trends can help you adjust more quickly.
Revenue represents all of the income coming in during the reporting period. It also includes any interest realized from investments. This includes sales of goods or services.
Expenses report the cash going out of your business during the reporting period. This includes the cost of buying goods, paying employee salaries and miscellaneous expenses, such as advertising. You also record a loss from investments.
Small Business Financials Formula: The Income Statement
In calculating your income statement, this formula is helpful:
Net Income = Revenue – Expenses
The Cash Flow Statement
Your small business financial reports will also show your cash flow. An income statement tells you whether you made a profit during the reporting period. A cash flow report will tell you whether you actually generated or lost cash during that same time.
Your cash flow statement is broken down into three parts and each track money coming into and out of the business.
Operating Activities are the core activities of how a business generates revenue and how it spends it. Cash from the sales of goods and services are recorded as a cash inflow whereas wages and the purchasing of goods are recorded as cash outflows.
Investing Activities detail any changes in your cash position realized from the purchase or sale of property, equipment or hard assets.
Financing Activities record the change in cash levels from issuing bonds, buying back stock or any payments (such as interest or dividends) to shareholders.
The Budget Comparison
Every business should have a budget that is used as the basis for your financial planning. It will be set up on either the calendar (January through December) or a fiscal calendar (any 12-month period beginning and ending on any chosen month. For example, October through September).
Your budget is your financial plan for the year and what you project will happen based on the information you have at the time you prepare it.
A budget will examine available capital, anticipated revenue and estimated expenses. It works as a framework for your business and allows you to track success against your goals.
Broken down into line items, it helps you measure if you are meeting revenue goals by product or service, and whether you are hitting the margins you need. Likewise, expenses are broken down by line item so that you can measure whether your spending is in line with your projections.
Your budget comparison shows how your business is doing each reporting period against your plan. This helps you track trends in revenue growth (or loss) and expense growth (or savings).
It’s a moving target every month. More sales will bring in more revenue but is also likely to increase your expenses. Fewer sales than anticipated can lead to fewer expenses, especially if your business pays employees on commissions or incentives based on revenue targets.
Tracking your actual performance against budget allows you to make adjustments in the future to help keep your business on track.
Most businesses compare monthly or quarterly against their budget as well as the current month’s performance against the same period from the previous year. It’s also helpful to track against your annual goals to determine whether you are pacing ahead or behind.
Track and Measure Your Business Success
The three parts of your small business financial statement are all related. Changes in your assets and liabilities on your balance sheet will also be reflected in the income statement showing revenues and expenses. These will show up in your gains and losses.
Each of the financial statements is important, but none of them tell the entire story. When combined, however, they can be a powerful tool for business owners.
Tracking your assets, liabilities and cash flow tells you the current state of your business. Tracking against your budget plan gives you a concrete way to measure performance and make adjustments as necessary.
Accurately tracking your financials is critical to running the day-to-day operations. It’s also essential if you need funding from outside sources such as investors or financial institutions. It also makes filing your taxes a lot easier.
We hope this beginner’s guide to financial statements gives you a quick overview to help you understand your financial statement.