A Quick Guide to Financial Statements
Understanding financial statements is crucial for the success of a small business. Business owners who regard them merely as a paperwork headache or necessary evil, miss out on the insights these statements contain on the company’s financial health - insights that could help improve the business, or in extreme cases, keep it afloat. Financial statements essentially trace the journey of your company’s money: where it came from, where it’s been, and where it is now.
Analyzing financial statements can help you:
- Determine when cost increases are outpacing revenue gains so you can negotiate prices with suppliers or make production more efficient
- Identify negative cash flow from operations and correct underlying problems in the business
- Find out whether your cash position is improving or worsening
- Compare your profit margins to other companies in your industry
The four main financial statements are balance sheets, income statements, cash flow statements, and statements of shareholder equity. We’ll take a look at the three most essential tools for every small business.
A balance sheet provides a snapshot of a company’s net worth based on what it owes and what it owns. The information captured on a balance sheet can help evaluate the company’s worth over time, and consequently gauge its ability to pay back loans or long-term expenses.
Balance sheets are set up according to a simple equation: assets must balance the sum of a company’s liabilities and shareholders’ equity.
|Valuable things the company owns, tangible and intangible||Obligations owed to others||Money left if company sold all its assets and paid off liabilities|
|E.g. cash, investments, trademarks, patents, inventory, equipment, real estate, accounts receivable||E.g. loans, rent, payroll, taxes, obligations to provide goods or services to customers in the future||Also called “capital” or “net worth.” A negative equity makes securing financing difficult; positive equity means you can get capital through equity, stocks, or dividends|
|Organized by liquidity:|
• Current: Expect to convert to cash within the year
• Noncurrent: Expect to convert in over one year
Fixed: Used to operate business, not for sale
|Organized by due date:|
• Current: Expect to pay off within the year
Long-term: Expect to pay off in more than one year
|• Opening Balance Equity: Initial investments
• Capital Stock: Common and preferred stock issued
• Dividends Paid: Profits paid out to shareholders by a corporation
• Owner’s Draw: Portion of revenue a sole proprietor uses
• Retained Earnings: Sum of a business’ consecutive earnings
Also known as “profit and loss statements,” income statements directly address the bottom line by reporting how much a company has earned and spent over a period of time. If the revenues and gains minus expenses and losses is positive, the statement shows net income. If the reported amount is negative, it is a net loss.
Income statements measure the following aspects of profitability over a defined period, typically a fiscal quarter or year:
- Change in sales revenue
- Change in profit margins
- Change in profits
It is important to note that income statements consider income earned rather than income received, and expenses incurred rather than expenses paid. To complete one, you will need to know all your business’ revenues and gains, as well as expenses and losses.
Cash Flow Statements
Officially termed “the statement of cash flows,” this statement shows the cash generated and used over a defined period, in the following areas:
- Operating activities: Cash flow from a business’ main activities.
- Investing activities: Cash flow from buying and selling assets other than inventory.
- Financing activities: Cash flow related to raising and repaying share capital, debt, interest, and dividends.
The cash flow statement is an important supplement to the income statement, because it accounts for the actual collection of revenue and payment of expenses. If cash from operating activities is less than net income for example, the business will need to do a better job managing its cash inflows and outflows.
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