Small to medium-sized businesses seldom have the luxury of hiring a CFO, or outsourcing one, to examine all of their financial data. As a business owner, this leaves the responsibility of understanding your business’s financial statements in your hands.
Luckily for you, there is no reason to panic. Financial statements may appear complex and intimidating at first glance, but they are much easier to master than you think. Forget about your fear of numbers and finance. There is no need to conduct over-complicated analysis or be put-off by financial jargon.
Financial statements are the most useful tools you can employ to understand the current & future financial health of your business. They are your best friend, and your ability to understand them is critical.
To understand financial statements, it’s important to understand the big three: income statement (also referred to as the profit and loss statement, or P&L), balance sheet, and statement of cash flows. Let’s take a quick look at each of them.
Income Statement (P&L)
The income statement (also known as a P&L statement) provides a breakdown of revenues and expenses in a business, and understanding P&L statements gets you critical insight into profitability over a period of time. The P&L has three main sections:
This section of the P&L provides detail on the amounts and sources of revenue the company is generating. It is best to have this broken out by sales channel or line of business offered. This will allow for insights into operational successes and improvement points.
Cost of Goods Sold
The Cost of Goods Sold (COGS) or Cost of Sales (COS) section, accounts for expenses that are directly related to the revenue generated. By deducting COGS from Revenue, it is easy to see if the core product or service offering is generating an acceptable gross profit.
Operating expenses relate to the general expenses necessary to run a business, such as utilities, rent, and office supplies. Once these expenses are removed from gross profit (Revenue – COGS), you will be able to determine if the company is generating net income.
What else can you tell by examining an income statement?
- Is my company growing or not? At what pace?
- What are the gross, operating, and net profit margins?
- Are my operating expenses at a healthy level? Could I handle sales growth with my current levels, or do I need to invest?
- What are my sales compared to a prior period (e.g. month over month, year over year)?
A balance sheet provides a snapshot of your business’s assets, liabilities, and owners’ equity. It provides an instant picture of a company’s financial underpinnings at a particular point in time. It’s divided into three sections:
This section comprises items of current and future value. Current assets include things like cash, accounts receivable, and inventory. These items are described as current assets because they are on the balance sheet for one year or less. Non-current assets stay on the balance sheet for longer than one year and commonly include things like buildings, equipment, and furniture.
Obligations for which the company is responsible, the liabilities section similarly gets split into current & non-current, and the same rule applies. Current liabilities include items like accounts payable, credit cards, and short-term debt. All of which must be paid within a year. Non-current liabilities include things like long-term debt.
The difference between assets and liabilities, this section represents the owners’ investment, less withdrawals, plus cumulative profits or losses since the company started.
What can you tell by examining a balance sheet?
- Does your company have enough cash liquidity or working capital?
- Can your business cover all its commitments over the next year?
- Do you have too many obligations that could cause you to run out of cash?
Statement Of Cash Flows
The statement of cash flows gives you the ability to see all the cash going in and out of your business. It’s divided into three segments: operations, investing, and financing. Pay most of your attention to the operations section, as it provides information on how much cash you are generating/burning from daily operations.
What can you tell by examining a cash flow statement?
- Where is your cash coming from and where is it going?
- Does your business have more money going in than going out?
- Are operations generating cash, or are investing and financing activities covering operations?
The Next Step: How to do a Financial Statement?
Managers, investors, and lenders rely on financial statements to determine a business’ financial position. An income statement and balance sheet are used for this purpose, with the balance sheet indicating a specific date and the income sheet indicating activity over a longer period.
Preparing the Balance Sheet
The balance sheet should list assets, liabilities, and the difference between them, which is the business owner’s net worth. Updating the general ledger with journal entries containing all necessary adjustments for certain items (depreciation, account mispostings, etc.), footing the ledger accounts to reach period end totals, and preparing an adjusted trial balance from the ledger entries completes the balance sheet.
Preparing the Income Statement
Preparing the P&L statement should include all income and expenses. The tax return will base your potentially taxable income on a modified income statement. After recording total sales minus returns and allowances, calculate the gross profit by subtracting the cost of goods sold like materials, direct labor, and other project-associated costs from the total sales.
Closing the Books
Close entries in the general journal to prepare for the next accounting period. To do this, clear out all income and expense accounts in the ledger, and then transfer the net income to the owner’s equity account.
When prepared correctly and reviewed regularly, these three financial statements provide a complete picture of your business’s finances. Further guidance and information can be found here.