If you’re unfamiliar with them, financial statements can seem like a mysterious art, better left to accountants and other money wizards.
Good news: You don’t need an ancient book of knowledge to understand financial statements. This simple guide to using financial statements demystifies the basics so you can use them to build your business.
Table of Contents
What Are Financial Statements, Exactly?
A financial statement (or financial report) is a document that tells you:
- Where your money comes from
- Where your money goes
- What funds you currently have on hand to work with
Financial statements summarize your accounting info in a way that’s (relatively) easy to understand. They’re created on a regular basis. This means either a monthly or quarterly accounting period for most small business owners.
There are a few kinds of financial statements you can use. Each one has a different purpose and gives you a different angle on your company’s financial performance. They also give you all the info you need to file taxes for your business.
There are 3 essential financial statements for businesses: The balance sheet, the income statement, and the cash flow statement. These statements must be created using generally accepted accounting principles.
How to Create a Financial Statement
You can generate your financial statements in 3 different ways:
- Software. If you use accounting software, it will automatically generate financial statements for you. Your statements can only be as reliable as your accounting, so keep inputting accurate, current information about your income and expenses.
- Bookkeeper. Many bookkeepers—including online bookkeeping services—will generate financial statements for you, and also make sure your financials are accurate and up-to-date.
- Accountant. You can send your bookkeeping data to an accountant, and they’ll create financial statements for you.
Okay, you’ve generated the key financial statements. Now what? Understanding what to look for in these three statements is part science, part art. Here’s what you need to know.
How to Read the Balance Sheet
Your balance sheet is a snapshot of your business’s current financial position. It clearly shows how much your business owns and owes: Its overall financial worth, or “book value.”
A balance sheet displays your assets, liabilities, and shareholder equity at a specific point in time. This tally must show a balance between your assets and the total of your liabilities and equity.
Most companies have a regular reporting date, either monthly or quarterly. Use whatever frequency your financial policies, lender requirements, or regulations define.
The beauty of a balance sheet (especially one that’s automatically generated and just a click away in your FreshBooks account) is that you can check in on your business at any time that’s useful to you.
Balance Sheet Structure
Your balance sheet is split up into three parts: assets, liabilities, and owner’s equity (or shareholders’ equity, for partnerships and LLCs). The conventional layout is to have your list of assets on the left, or at the top. And your liabilities and equity on the right, or on the bottom.
Business assets are everything that your company owns with a value that’s quantifiable in dollars.
- Accounts receivable: Outstanding invoices for goods and services that you’re expecting to be paid by your clients and customers
- Cash: The ending balance in your bank accounts as of the balance sheet date
- Cash equivalents: Like certificates of deposit and Treasury bills
- Physical items: Buildings, equipment, machinery
- Inventory: Everything from raw materials to finished products waiting for distribution
- Intellectual property: Patents, trademarks, brands, and other intangibles
On the balance sheet, your assets must be listed in order of liquidity. This means, how quickly they can be turned into cash. Current assets (cash and assets you expect to turn into cash within a year) are at the top. Non-current or long-term assets (those that would take longer than 1 year to convert to cash) or fixed assets (not for sale at all because they’re needed for the company’s operations) go toward the bottom.
Business liabilities are the other side of the same coin: They are what your company owes to other people, organizations, or companies.
Liabilities can take many forms, including:
- Property rent owed
- Utility bills
- Invoices from stock suppliers to be paid
- Payroll you owe employees
- Income taxes and any other taxes owed to tax authorities
- Money owed on bank loans and mortgages
- Credit card payments due
- Contributions due to employee retirement programs
- Payable dividends that are due to your stockholders
Liabilities should be listed on the balance sheet in order of payment due date, with the closest at the top. These are split into current liabilities, which will be paid within 1 year, and long-term liabilities, which take longer than a year to repay—typically things like bank loans.
Owners’ equity, also known as shareholders’ equity or stockholders equity, is the money that either you or investors have put into your business, plus either the retained earnings or losses incurred by the company’s performance.
It’s considered the net worth of your business because it’s the amount that would be left if the business sold all its assets and paid off all its liabilities.
Balancing the Equation
The best way to understand how the 3 sections of the balance sheet work together is to remember this equation:
Assets = Equity + Liability
The two sides of that equation must always be in balance.
How to Use Your Balance Sheet
Balance sheets show your company’s financial position. They are used for different reasons by people inside the business versus interested parties looking from the outside.
As a business owner, a balance sheet shows you how well your business is doing. Is your company’s financial condition looking positive or negative? It helps you identify problems, expand your successes and discover new opportunities. With it, you can:
- Track your financial performance over time
- Track debts you’ve paid off
- Manage loans
- Demonstrate how investors’ money is being used
- Keep track of liquidity and working capital
The information from this particular financial statement can really help you prioritize and plan for future business success.
From an external viewpoint, balance sheets provide investors with crucial company information in a concise format. For example, auditors can check reporting compliance by using your balance sheet. And potential investors can clarify the company’s worth and its financial makeup, so they know whether your business is a good investment based on financial ratios or comparisons to other businesses in the same industry.
Like any financial statement, it’s only useful if you use it wisely. You can show your debt-to-equity ratio and liquidity using your balance sheet figures. That’s why it’s important for you to be able to read your own balance sheet so you can use it to your business’s advantage.
How to Read the Income Statement (Profit-and-Loss Statement)
Your balance sheet tells you how much money you have to work with—and how much you owe—but it doesn’t tell you how you got there.
That’s where the income statement, or profit-and-loss statement (P&L), comes in. It tells you how much money you’ve earned and how much you’ve spent over the course of the month, quarter, or year.
Income statements show your company’s revenues and expenses to arrive at your net income for that given period. Public companies also report earnings per share (EPS) on their income statements. This financial statement is generated monthly, quarterly, or annually.
Income Statement Structure
Your income statement lists revenue followed by expenses for a chosen time period, with your net profit at the bottom.
The top of your income statement lists your gross revenue for the time period. That is, how much you’ve taken from customers for goods and services you’ve provided before any deductions are made. This figure is commonly called the top line.
You list all your revenue on your income statement in 3 separate categories:
- Operating revenue: All the money you make from your main business operating activities selling products or services
- Non-operating revenue: Any other money your company earns. For example, royalties, advertising space, property rental, and straightforward bank interest.
- Other income: Revenue from one-off activities that don’t fit into the other categories. For example, the sale of plant machinery or physical property. Gains from selling assets would also be “other income.”
From here, you subtract your cost of goods sold (COGS). These are all your production and raw material costs. The resulting figure is your gross profit.
All your operating expenses should be listed by category or type. Common operating expense categories include:
- General expenses, like utility bills and wages
- Administrative expenses
- Selling costs (advertising, marketing, distribution)
- Depreciation of assets
- Research and development investment
- Other operating expenses
Other expenses are often long-term costs. Like interest expense on mortgages and business loans. This is also the place to list any losses from the sale of assets, as they fall under other expenses.
Net Profit or Loss
After all the expenses are deducted from revenue, you end up with the company’s net profit or loss. A profit is sometimes called net income or net earnings. This is written at the bottom of your company’s income statement (the business’s actual “bottom line”).
How to Use Your Income Statement
A high net income figure at the end of your income statement provides you and your investors with confidence in your current financial results and interest in your future growth.
You can also dig into the details of particular aspects of your income statement. For example, if you look into more than one reporting period’s financial data, you can show how sales are increasing over time. Or how you’re steadily bringing down costs to increase profit margins.
Your income statement can work for you as a business owner on so many levels. With it you can:
- File accurate taxes
- Track the long-term impact of your business activities on profitability
- Get a bird’s eye view of your deductible expenses
- Show your business is successful and sustainable by highlighting your net income figure over a period of time
- Investigate expenses to see if efficiencies can improve your net income
How to Read the Cash Flow Statement
Cash flow is the lifeblood of your business. Monitoring cash inflow and cash outflow is the third way to gauge your company’s financial health. It gives a clearer picture of company liquidity than the income statement or balance sheet. Basically, it answers the question, “Do I have enough cash to pay my bills, debt, and production costs, and to invest in future developments?”
Cash flow statements literally show where cash flows into your business and where it leaves— your cash inflows and outflows. This measurement is taken over a set period: Either quarterly, annually, or year-to-date. It uses the information you’ve already assembled in your income statement and balance sheet to show the net cash increase (or decrease) at the end of the reporting period.
Cash Flow Statement Structure
Cash flow statements contain 3 main sections. These look at your cash flow in 3 different areas of business activity: Operating activities, investing activities, and financing activities.
Operating activities: Includes revenue and expenses to show the cash flow created by the business’s primary activities—providing goods or services. This begins with the net income shown on your income statement.
Investing activities: Cash flow from buying and selling physical and intellectual assets. This only applies to purchases that aren’t funded by debt.
Financing activities: Cash flow from equity (selling shares or bonds) and debt financing (bank loans).
Using Your Cash Flow Statement
Every business is aiming for a positive cash flow, which means that your operating income revenue is higher than your net income. Essentially, your cash flow statement provides this evidence, showing how you generate cash and how it flows through your business over a period of time.
Financial Statements Can Make or Break Your Business
By getting your head around all your financial statements, you build a detailed understanding of your company’s cash flow, profitability, and entire financial position. Between all 3, you get a snapshot and long-term view of how well the business is really doing.
Using these 3 statements you can rectify any issues, plan future growth and, ultimately, increase the company’s net worth.
Additionally, financial statements are the evidence you need to back up any investment you might be looking for. Potential investors will want to see the figures and hear your explanation of them.