There is a lot of information to digest when looking at financial statements. They can be overwhelming for the average person. However, if you take the time to learn how to read and understand them, they can provide valuable insights into the health of your business. In this comprehensive guide, we will break down each section of a financial statement and explain what it means for your business. We will also provide some tips on how to improve your understanding of financial statements. So, let's get started!
The first thing to know about financial statements is that they come in three different types: the balance sheet, the income statement, and the cashflow statement. Each one provides different information about your business.
1. The Balance Sheet
A balance sheet is a snapshot of your business's financial health at a specific point in time. It lists all your assets (what you own) and liabilities (what you owe). From this, you can calculate your net worth.
2. The Income Statement
An income statement shows your business's profitability over a period of time. It lists your revenue and expenses; the difference between the two is your net income.
3. The CashFlow Statement
A cash flow statement shows how much cash is coming into and going out of your business. This is important to track because it can help you avoid running out of money.
Now that you know the basics let's take a closer look at each type of financial statement.
The balance sheet
Also known as the statement of financial position, the balance sheet lists all your assets and liabilities at a specific time. Thus, the balance sheet is a snapshot of your business's financial health at a specific point in time. It lists all your assets (what you own) and liabilities (what you owe). From this, you can calculate your net worth.
Your assets are everything you own and can use to pay your debts. They can be divided into two categories: current assets and non-current assets.
Your current assets are those that can be converted into cash within one year. These are important because they can be used to pay your short-term debts. Examples of current assets include cash at hand and the business bank account, accounts receivables, and inventory.
Your non-current assets are those that will take longer than one year to convert into cash. These are important because they can be used to pay your long-term debts. Examples of non-current assets include property, plant, and equipment.
The second section is your liabilities. As we mentioned before, your liabilities are everything that you owe. They can also be divided into two categories: current liabilities and non-current liabilities.
Your current liabilities are those that you will need to pay within one year. These are important because they can affect your ability to pay short-term debts. Examples of current liabilities include accounts payable and short-term debt.
Your non-current liabilities are those that you will not need to pay within one year. These are important because they can affect your ability to pay long-term debts. An example of a non-current liability is long-term debt used for business funding.
The third and final section is your equity. Your equity is the difference between your assets and your liabilities. It shows how much you own of your business. Equity can be divided into two categories: common stock and retained earnings.
Common stock is the portion of ownership that you have in your business. If you own 100% of the business, then you have 100% common stock.
Retained earnings are the profits that your business has made over time. These can be reinvested into the business or used to pay dividends to shareholders.
Your net worth is calculated by subtracting your liabilities from your assets. This number can be positive or negative. A positive net worth means that your business is in good financial health. A negative net worth means that your liabilities are more significant than your assets, which is not a good sign.
The income statement
Also known as the statement of profits and loss (PNL), the income statement shows your business's profitability over a period of time. It lists your revenue and expenses; the difference between the two is your net income.
The first section is your revenue. This is the money that you have earned from selling products or services. It is important to note that revenue does not equal profit. Just because you have earned a lot does not mean you are profitable.
The second section is your expenses. These are the costs associated with running your business. They can be divided into two categories: cost of goods sold (COGS) and operating expenses.
The cost of goods sold (COGS) is the direct cost of producing your product or service. Examples of COGS include the cost of materials, the cost of labor, and the cost of shipping.
Operating expenses are the indirect costs associated with running your business. Examples of operating expenses include rent, utilities, and advertising.
The difference between your revenue and your expenses is your net income. This is also known as your bottom line. If your net income is positive, then you are profitable. If your net income is negative, then you are not profitable.
The cash flow statement
The cash flow statement shows how much cash is coming into and going out of your business. This is important to track because it can help you avoid running out of money.
There are three types of cash flows: operating, investing, and financing.
Operating cash flow is the money that comes into and goes out of your business from everyday activities, such as sales, expenses, and inventory. Investing cashflow is the money that your business invests in long-term assets, such as property or equipment. Financing cashflow is the money your business borrows or raises from investors, for example, ACH transfers, merchant cash advances, credit cards, etc. Tracking all three types of cash flows is essential because they can significantly impact your business's overall financial health. For example, if your operating cash flow is negative, it means that you're spending more money than you're bringing in from sales. This can quickly lead to financial trouble. On the other hand, if your investing or financing cash flow is positive, it can help offset a negative operating cash flow and give your business some breathing room.
Now that you know the basics of financial statements, you're ready to start reading and understanding them! Here are a few tips:
1. Read all three statements. Don't just focus on one. They all provide different but important information about your business. Additionally, most businesses will have all three statements available on their website in their investor relations section.
2. Compare the statements from different periods. This will help you see trends and identify areas that need improvement. Comparing also helps spot outliers, which can help you understand your business better.
3. Read the footnotes. These often contain important information about items on the financial statements. For example, the footnotes might explain why a certain expense is higher than usual or why revenue is lower than expected.
4. Use financial ratios. Ratios are a quick and easy way to compare different numbers on financial statements. They can help you spot trends and identify areas that need attention. There are dozens of different ratios that you can use, so it's important to choose the right ones for your business. A few common ratios are:
- Gross margin: This measures how much profit your business makes on each sale. To calculate it, divide your gross profit by your revenue.
- Operating margin: This measures how much profit your business makes after all expenses are paid. To calculate it, divide your operating income by your revenue.
- Return on assets (ROA): This measures how profitable your business is relative to its size. To calculate it, divide your net income by your total assets.
- Return on equity (ROE): This measures how well your business uses the money that investors have put into it. To calculate it, divide your net income by your shareholders' equity.
5. Hire a professional. If you're unsure how to interpret the financial statements, hire an accountant or financial analyst to help you. They can answer your questions and give valuable insights into your business's finances.
6. Use the statements to inform your business decisions. Financial statements are a powerful tool that can help you make better decisions about your business. For example, if you're considering expanding your business, you can use the cash flow statement to see if you have the money to finance the expansion. Or, if you're thinking about hiring new employees, you can use the income statement to see if your business can afford the additional salaries.
Importance of Reading and Understanding Financial Statements
Financial statements are an important tool that can help you understand your business's financial health and make informed decisions about its future. However, reading and understanding financial statements can be challenging, especially if you're not a financial expert. That's why it's crucial to hire a professional accountant or financial analyst to help you interpret the numbers. Additionally, using financial ratios and comparing the statements from different periods can also be helpful. By reading and understanding your financial statements, you'll be in a better position to make decisions that will help your business grow and succeed.
