Business owners guide to reading financial statements like a pro
As a business owner or startup founder, you may be well versed in finance or it may not be your forte, but regardless of your skill level, financial statements are a crucial aspect of running a successful company. And to some non finance professionals, they may seem a little confusing to read as if the statements are just list of random figures and numbers. Ever heard of a 10-k? Guess what, It has nothing to do with running a marathon. However, having the insights to quickly read and accurately interpret them, financial statements can reveal a lot about the financial health of a business. Having the ability to evaluate profitability, organizational performance, financial strength, and cash flow analysis is a knowledgeable skill that can help you contribute to the conversation with your CFO and add a critical dimension to your leadership strengths. This article will help break down every section of a financial statement, what each section means, and how they relate to one another. A company called Scale Factor that is closing its doors due to Covid-19 crisis put together a pretty interesting article by Robert MacNaughton, a CPA on this topic but it is now only available through an archive.
And guess what, you do not need to be Warren Buffet or a professional CPA / CFO, to read and understand them. With a little guidance and practice any business owner can learn to use their financial statements to drive smart business decisions. Become more financially literate, and speak balance sheet language fluently.
Think of them like a report card for your business. Their purpose is to show how money has moved through the company and to show that information from different angles. Together, the three primary financial statements—the income statement, balance sheet, and cash flow statement—provide an holistic view of a company’s finances.
This article, will cover and break down:
- The Basics: What are the three primary financial statements?
- Why financial statements matter to business success
- Best practices for reviewing your financial statements
Also how to read the:
- Income statement
- Balance sheet
- Cash flow statement
Financial Statement Basics
Financial statements are meant to be historical records of what happened during the accounting period before. They can be calculated on a monthly, quarterly, annual, or ad hoc basis. However, it would be difficult (and likely not worth the time required) to create these reports more often than once per month.
The reason these reports can’t be created in real time is that, as historical records, it’s important that a company’s financial statements be 100% accurate. Not only will this accuracy help you understand the true state of your business, but it will be required when it’s time to file taxes.
After a month or each financial quarter wraps up, it’s time to “close the books,” or finalize all the journal entries that took place over that time period. Closing the books is an old school accounting term (even though accounting has mostly gone digital with software) that basically means that all the transactions within a certain period (usually a month) were accounted for so that the information provided in reports like the balance sheet and income statement would be accurate for that period. The way accountants went about closing the books in the past was a much more manual process, but the goal remains the same. Now closing the books can be a bit of a time consuming process, especially if you have not been keeping your records or bookkeeping up to date on a regular basis. However, once all the information is accounted for and books are closed, the next step is to create financial statements for business owners and leadership to review.
The financial statements follow guidelines outlined in GAAP or generally accepted accounting principles. The 3 most common financial statements each help answer a different question for business owners or investors. According to a startup accounting software company that wrote article about this called Scale Factor, They are:
- The Income Statement: How did we do?
- The Balance Sheet: Where are we at?
- Cash Flow Statement: How much cash is left?
If you have all three of these statements prepared together, it can give a pretty good snapshot of the financial health of the business. Each statement can be analyzed separately, which can help finance teams or management to dive deeper into any possible financial related issues or questions they uncover and investigate the potential causes more thoroughly.
A Few Reasons Why Some Small Business Owners Avoid Them
So if financial statements are so important to a business owner, then why do many owners avoid reading and reviewing them and a consistent basis? And even more so why some only opt to create them during tax season instead of on a monthly or a least quarterly basis?
Some of most common complaints from small companies about financial statements revolve around two main issues:
- Sometimes a little difficult to understand: Financial statements are made by accountants, typically with financial professionals in mind. They’re not naturally intuitive to business owners without a finance background.
- Information can become outdated quickly: When it takes 30+ days to learn how your business did the month before, it’s hard to put that information into action.
(image credit: Scale Factor)
And don’t get me wrong these are valid concerns or pet peeves. The problem is that in general financial statements aren’t naturally intuitive, and they can be a sort time consuming to create. That said, these obstacles can be easily overcome and are no legitimate reason to avoid reviewing statements going forward. As I have written about before in a post titled Top 11 reasons that startups fail, One of biggest reasons is Cash flow, an issue cited as a common problem and a large cause for startups failing and going out of business. So meaning business owners who are not taking control and monitoring their finances can lead to poor cash flow management, and when that happens it can lead to stress, fear, and even the end of a business.
The Scale Factor article states that “because most businesses run on accrual basis accounting, keeping track of cash is made even more difficult. You can’t simply check your bank account and know that you’ll have enough in the bank to cover upcoming expenses.
This is where financial statements come in. They can help make sense of where your money is using accrual accounting and help avoid major cash flow issues.”
Cash vs. Accrual Accounting
The two methods of accounting—cash and accrual—are designed to serve different purposes.
Cash basis accounting recognizes revenue and expenses when cash changes hands. If a customer bought a product or service from you in July, your July reports would show the transaction. It’s an easy-to-understand method, but it’s limited.
The accrual method of accounting recognizes revenue and expenses when incurred. If you sent an invoice in July and your customer paid you in August, you’d recognize the income in July. Accrual accounting is more complex to understand, but it provides a better long-term view of your business. The only real downside of accrual accounting is that it makes tracking your cash more challenging.
Keep in mind that through the income statement and cash flow statement, your financial reports show not only all the revenue and expenses you recognized over a period but also all the cash that moved in and out, making accrual accounting easier to navigate.
The Income Statement
The income statement, also known as the profit and loss statement (or simply P&L statement), shows a company’s financial performance over a set period of time, like a month or quarter. Performance is measured through revenue and expenses that took place during that period. Because it’s a measure of sales performance, as well as operational efficiency, the income statement answers the question: “How did we do this quarter?”
Income statements also include information for shareholders. By reporting earnings per share, these statements show how much shareholders would receive if net earnings from that period were distributed.
Let’s demystify the sections of the income statement and what they mean to you, the business owner or founder.
The very first section of the income statement shows all the revenue your business generated over the period. Total revenue goes by many names. So if you see net sales, net revenue, gross sales, or gross revenue, they all mean the same thing. This is how much money you made before any expenses are taken out.
Cost of Goods Sold
Next up is cost of goods sold, also known as cost of sales or simply COGS. This includes the cost to produce goods, cost of services rendered, and cost of inventory. Expenses in this section include:
- Cost of raw materials
- Cost of labor
- Commission for employees
Cost of goods sold is typically a variable cost, meaning that the more you sell, the more you’ll need to produce those goods. Therefore, COGS also goes up.
After the cost of sales expenses have been deducted, you’ll see the company’s gross profit, also called gross income. Gross profit will be used to cover all of the company’s other expenses.
Gross Profit = Total Revenue – COGS
Next, operating expenses will be listed. These are also referred to as Selling, General, and Administrative expenses (SG&A) and show general expenses of a company’s operation. This will include expenses such as:
- Administrative salaries
- Marketing expenses
- New product research
- Depreciation expense (wear and tear on assets over time)
Below operating expenses, you’ll see operating profit, also known as operating income. This represents earnings from a company’s normal operations before any additional income or expenses are considered.
Operating Profit = Total Revenue – COGS – Operating Expenses
Interest Income and Expense
Interest income and expense will be listed next. It is the money made by a company from anything that earns interest, such as money market funds or savings accounts.
Income expense, on the other hand, is money that a company must pay to cover the interest on money they have borrowed.
Income tax is estimated and is the final deduction made on the income statement.
The Bottom Line
Income statements are where the phrase “bottom line” comes from. Once all expenses have been deducted from earnings, what’s left is considered net income. Like most other elements of the income statement, it goes by a few names like, net profit, earnings, or net earnings.
A Few Tips On How To Read the Income Statement
The best way to read the income statement is to understand each section and how the numbers you see are calculated, but there are a few quick tips to keep in mind as you scan your next statement.
- Start at the Top: Is total revenue in line with what you were expecting? Every business should set sales goals for each month or quarter to manage growth. Check your revenue against those goals.
- Look at the Bottom Line: The same goes for net income—you should set goals for this too. Check your net income against your goals. Is it close to what you expected?
- If You Answered No: If your revenue or net income surprises you, it’s best to dig in a little more to find out what changed. Start by looking at your gross profit. Is it higher or lower than last time? That may signal a change in COGS, like a vendor charging more and cutting into your margins. Also take a look at operating income. Were your everyday expenses higher than normal? If so, what caused it?
Important Metrics from the Income Statement
There are many calculations you can perform from the income statement. One of the most common is gross margin, which is calculated by dividing total revenue by gross profit. Simply put, out of every $1 you make, the gross margin shows you how much of that dollar is left for expenses after the cost of sales is deducted.
Gross Margin = Total Revenue / Gross Profit
Other helpful metrics may include EBIT or EBITDA, which show earnings before expenses like taxes, interest, or depreciation and amortization. Scale Factor offers a free EBITDA calculator
The Balance Sheet
The balance sheet provides a quick look at company assets, liabilities, and shareholders’ equity at a given point in time. Unlike the income statement, the balance sheet does not show performance over a period of time. Instead, it shows cumulative totals and outstanding payments. In other words, it’s a snapshot of a company and answers the question: “Where are we at this Quarter?”
The balance sheet fundamentally relies on the accounting equation, which says that a company’s assets must equal the sum of its liabilities and shareholders’ equity.
Assets = Liabilities + Equity
On one side of the balance sheet are assets, or what a company possesses. And on the other side are liabilities (what a company owes) and equity (what’s left over).
An asset is anything a company possesses that has value. An asset can be something that is directly sold or something that is used by the company to sell a service or to manufacture and sell a product that can be sold.
Assets can include:
- Accounts Receivable
- Company investments
- Physical property, such as product inventory, buildings, and equipment
Types of Assets on the Balance Sheet
There are two types of assets, usually listed on the balance sheet according to how fast they can be converted to cash, or liquidated.
Current assets are those that a company expects to quickly convert to cash, usually within a year. They have high liquidity, in other words. Examples of current assets are:
- Prepaid expenses
- Accounts receivable
Non-current assets are ones that would take a company longer than a year to sell. Examples of non-current assets are:
- Long-term investments
- Investments in other companies
- Intangible assets such as brand recognition
Non-current assets also include fixed assets. Fixed assets are not sold or used by a company but are used to produce goods and services.
Fixed assets include:
- Equipment and machinery
- Computer equipment and software
- Intangible assets such as copyrights, patents, and trademarks
The liabilities section simply shows everything that the company owes. Liabilities, like assets, come in many forms, including:
- Employee payroll
- Government taxes
- Bank loans for new product launches
- Customer obligations
- Rent for buildings and equipment
- Money owed to material suppliers
Types of Liabilities on the Balance Sheet
Balance sheets list liabilities by their due dates.
Like current assets, current liabilities are those expected to be paid off within a year. Companies must be sure that they have enough to pay these when they are due.
Examples of current liabilities include:
- Accounts payable
- Sales taxes payable
- Payroll taxes payable
- Short-term loans
- Interest payable
- Customer deposits
Long-term liabilities are those that are not due within one year of the balance sheet’s date. Examples of long-term liabilities are:
- Long-term loans
- Pension liabilities
- Bonds payable
Shareholders’ equity, also called capital or net worth, is the amount of money that would be left if a company were to pay off all liabilities and liquidate all of its assets. That’s why it’s often thought of as “what’s left over.”
Shareholders’ equity will show the amount a shareholder invested in the company plus or minus any company earnings or losses.
Depending on your business’ entity type, the equity section of the balance sheet will look different. Some companies retain earnings, while others distribute them as dividends. Most opt for a blend of the two.
The retained earnings section, as the name implies, shows the cumulative profits from previous periods. For example, if at the end of last year your business had $300,000 left in profit after all expenses, taxes, and other costs were paid, you might decide to distribute some out to owners and to place the rest into retained earnings. If next year, you find yourself with another $300,000 in profit, you could see your retained earnings go up to $600,000.
In other words, it’s how much profit your business has made over the life of the business. When companies are looking to make a big purchase or investment, they may draw from retained earnings to afford it, like an average consumer might draw from savings to purchase a new car.
A Few Tips on How to Read the Balance Sheet
Start With Current Assets: Can you cover your current liabilities with them? If yes, you’re probably in fine shape for the short-term. If no, you’ll want to dig into your current liabilities more thoroughly. Map out when each payment is due and when you expect to have money coming into the business. Remember, current assets and current liabilities have a time frame of one year. So you may not be in immediate trouble if you can’t cover current assets. But you should dig deeper to make sure you’ll be able to cover liabilities when the time does come.
Retained Earnings: Next, look at retained earnings. If you are a new business, this number may be negative for some time. If you have a break-even goal, keep checking back to make sure that you’re nearing it on schedule.
Key Metrics from the Balance Sheet
Because the balance sheet shows a snapshot of time, the key metrics that can be gleaned from it are financial ratios. In other words, how does one area of the balance sheet relate to another?
The primary ratios to calculate are listed below in this table:
|Question||Ratio||Formula||What It Means|
|How much liability is there compared to equity?||Debt-Equity ratio||Total Liabilities / Total Shareholder Equity||How much of the company is owned versus owed.|
|How much leverage do you have?||Debt to Asset Ratio||(Short-Term Debt + Long-Term Debt) / Total Assets||Percentage of assets that were financed by debt.|
|What are your current assets minus current liabilities?||Working Capital||Current Assets – Current Liabilities||Shows if the business can meet obligations.|
|What are your current assets compared to your current liabilities?||Current Ratio||Current Assets / Current Liabilities||How much the business is bringing in versus paying out.|
Balance Sheet vs. Income Statement
It’s easy to confuse the balance sheet and the income statement, so if we were to sum up the key difference between them, it’s this: the income statement mostly deals with temporary accounts and the balance sheet mostly deals with permanent accounts.
Within your chart of accounts, you’ll have some accounts that are considered “temporary” and others that are considered “permanent.” A temporary account means that, at the end of an accounting period, the balance in that account will be zero. That’s because whatever funds were in that account will be transferred over to a permanent account.
Think of these accounts like your checking and savings accounts. You use your checking account for day-to-day spending, and you might move money over from your checking to your savings every month. Your checking account will go up and down depending on when you get paid and when bills are due, but your savings should generally keep going up.
To look at an example in your business, the Scale Factor article suggests “if you made $50,000 in revenue last quarter, you need your revenue accounts to be “zeroed out” at the end of the quarter so that you can monitor your performance in the upcoming one.” They went on to also say “so you’ll move that revenue amount over to a permanent account, like retained earnings. Like a savings account, permanent accounts are your running totals.”
So in terms of the income statement and balance sheet, think of your income statement as a summary of temporary activities and your balance sheet as a summary of all your past activities.
The Cash Flow Statement
The cash flow financial statement, also called the statement of cash flows, shows how much money is coming into and going out of a company. In other words, cash flow statements report how much cash a company generated during the statement period. Because accrual basis accounting makes keeping track of cash difficult, the cash flow statement supplements the income statement and helps business owners understand the true state of their cash.
There are three parts to a cash flow statement: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Each inflow or outflow of cash falls into one of these three categories, though the majority will likely fall under operating activities.
Cash Flow from Operating Activities
This part breaks down a company’s cash flow from everyday business activities. This means invoices that were collected, bills that were paid, employee paychecks that were paid. All of it. When the cash changes hands, those kinds of activities show up here.
Cash Flow from Investing Activities
This part shows cash flow from investments. These investments can include purchases or sales of long-term assets such as property or equipment. If a purchase is made, especially for expensive facilities or machinery used to produce goods, this is reflected as cash outflow.
If investments are sold by the company, the money made would show as cash inflow.
Cash Flow from Financing Activities
This section accounts for cash flow from any financing activity that company is involved in. Cash inflow occurs when capital is raised, like when companies issue bonds to the public or borrow from a bank.
Cash outflows occur when a company pays interest on loans or to bondholders, when they pay off loans, or when they distribute dividends.
A Few Tips to On How Read the Cash Flow Statement
- Start at the Bottom: Was your total cash flow positive or negative? In other words, did you bring in more cash than you spent? If so, that’s great. You had enough to pay all your expenses. If not, you’ll want to take immediate action to make sure you can cover all the expenses that are coming up next.
- Look at Cash Flow from Operating Activities: This section is closely tied to your operating income on the income statement. Explore both and compare them to the previous statement to identify what’s changed.
Best Practices for Preparing Your Financial Reports
The importance of financial statements to your business can’t be overstated. That’s why Huckabee CPA are firm believers that you should review them on a monthly basis. This is the best way to ensure that you are using your financial statements to drive smart, data-driven decisions.
The bare minimum for preparing financial statements is once a year because they are required for tax purposes. If you’re a small business owner with only a few transactions each month and no debt, you might be able to get by with this. However, the majority of businesses should review them more often.
If you do decide to seek a loan or a VC funding round from investors, you may be asked to prepare these due diligence tax and financial statements so that outside parties can evaluate whether or not they want to hand over financing. If seeking financing options is in your future, make sure that your books are always up to date so that you can prepare these statements easily and quickly, as soon as they’re requested.
When carefully prepared, compiled, reviewed, and managed, financial statements provide invaluable insight into a company’s profitability and viability. While they can be cumbersome to create, the value they provide far outweighs the headache of closing the books and reviewing them.
The faster they are created, the more relevant the information provided will be. You should look for an accounting solution provider that can help you close the books within days, rather than weeks, of the month’s end. That way, your financial information will not feel nearly as stale but will still remain an accurate historical record of what happened.
If you have any questions about financial reporting for your company or need help creating monthly financial statements feel free to contact Huckabee CPA for a free consultation.