Understanding Your Financial Statements
Mar 07, 2022
Unless you come from an accounting or finance background, you probably didn't get a great education in what financial statements are and why they are important in your business. Many owners that I talk to know they lack an understanding of their financial statements and would like to know more, but they don't know where to start. It all seems very overwhelming - different statements to learn, lots of terminology, figuring out how the statements interact and where the numbers come from - it's just too much.
It's true - there is a TON of information out there and a lot of it is written in a very technical manner, more for the student of accounting and finance than for a business owner trying to learn a major skill to help them succeed. If you don't know where to start, it's stressful and hard to make yourself want to learn it. That's okay, because I can help!
I won't try to cram everything into a single article. That would even stress me out!
I'll start slow. One building block at a time.
Here we go!
There are 3 primary financial statements that are used:
-
Balance Sheet
-
Income Statement (also known as the Profit & Loss Statement)
-
Statement of Cash Flows
Balance Sheet
The Balance Sheet lists out everything you own, everything you owe, and the amount of equity investment in your business.
It's broken down into three sections:
Assets = what you own (cash, accounts receivable, physical property & equipment, investments in other companies, etc.)
Liabilities = what you owe (accounts payable, credit cards, bank loans & lines of credit, property & equipment leases and notes, etc.)
Equity = net owner investment in the company (owner contributions, shares of company stock, retained earnings, minus distributions)
Balance Sheet Formula: Assets = Liabilities + Equity
The total value of your assets equals the total value of your liabilities plus the total value of your equity.
You should be aware of this formula, but your software does all the math for you based on how your transactions are entered into the system, so you don't really need to do anything with this yourself.
The Balance Sheet keeps a running total of all of the transactions that are posted to the different accounts on the Balance Sheet. It is a snapshot in time. Think about your bank account - your balance is just the total of all of the deposits and charges that have cleared your account up to that point. The entire Balance Sheet works like that.
Income Statement
The Income Statement lists out your sales and expenses for a specific period (usually by month, by quarter, and by fiscal year).
Net Sales - COGS - Operating Expenses + Other Income - Other Expenses = Net Income
Here's what all those terms mean:
Net Sales = total value of products and services sold for the period minus total value of returns and discounts granted for the period.
Cost of Goods Sold (COGS) = total cost of the materials and services required to produce the sales for the period (inventory cost, freight, 3rd party handling fees, etc.)
Gross Profit = Net Sales - COGS, represents the amount of money earned before taking into account operating expenses and other income / expenses not related to the sale of the product
Operating Expenses = These are costs that the business incurs to keep the doors open that aren't directly related to producing a product or service (office lease, bank fees, software subscriptions, meals, travel expenses, etc.)
Operating Income = Gross Profit - Operating Expenses, represents the amount of money earned after considering the cost of goods sold and operating expenses for the business
Other Income = the money a company makes that is not related to selling its products and services (dividend income from investments, interest income, gain on sale of assets, rebates, etc.). Other Income is separated out because it is not related to the operating activities of the company.
Other Expenses = total expenses that the company incurs that are not related to the operating activities of the company (depreciation expenses, loss on sale of assets, etc.)
Net Income = The amount of money earned for the period after taking into account all of the company's sales and expenses for the period
One thing to understand is that Net Profit is not the same thing as Available Cash.
One of the reasons for this is the timing of when you receive payment for your products and services and when you pay for your business expenses.
If you sell your product on 2/1, the sale is reported on your Income Statement for 2/1. If you collect payment on the sale on 2/1, then you record the cash which is on your Balance Sheet for 2/1. If you don't collect payment at the time of sale, then you record the sale on 2/1 and a receivable on 2/1 which shows up on your Balance Sheet.
Receivables represent the amount of money owed to you. They are a promise of payment from your customers. In this scenario, the sale is the same, but the way we handle the associated payment is different. I'll talk about this more in a later post when we learn about the Cash Conversion Cycle.
Statement of Cash Flows
The Statement of Cash Flows summarizes the change in cash for the period. It takes all of the cash related activities and breaks them down into types of activities to help give a high level view of how the company used its cash.
Beginning Cash + Cash from Operating Activities + Cash from Financing Activities + Cash from Investing Activities = Ending Cash
We begin with the Beginning Cash Balance for the period. This can be found on the Balance Sheet. The Beginning Cash Balance for the period is the Ending Cash Balance for the prior period.
Let's go back to your bank account. When you get your bank statement, it has the beginning balance listed. If you take a look at the bank statement for the prior month, the ending balance will be the same number. This goes back to the idea that accounts on the Balance Sheet are a summary of all transactions that have been posted to the account up to this point.
Cash from Operating Activities = cash in/out related to core operating activities
-
net income
-
depreciation & amortization
-
adjustments to net income
-
change in accounts receivable
-
change in liabilities
-
change in inventory
-
change in other operating activities
Cash from Investing Activities = cash in/out related to buying and selling long term investments, property, plant & equipment
-
purchase or sale of property, plant and equipment
-
investment in joint ventures and affiliates
-
Payments for acquisitions
-
Sale of assets
-
Investments in securities
Cash from Financing Activities = cash in/out resulting from changes in debt and equity accounts
-
cash dividends paid
-
partner distributions
-
change in short-term loans / lines of credit
-
change in long-term loans
-
purchase and sale of company stock
-
cash investment from partners
The Statement of Cash Flows is the hardest to understand because it can be difficult to break the transaction types out correctly if you're not familiar with them. Good news for all of us is that our financial software does this automatically for us, so we don't have to worry about it!
The important thing to remember is that this statement is telling us what happened to cash for the period.
-
Do we have more cash now than we had before, or less?
-
Did we collect a lot of receivables and/or pay down our debt?
-
Did we borrow money and/or buy property or equipment?
Ultimately, we want to have positive cash flow over time. If we lost cash, then we need to look at why so we understand what actions we took that caused it. For example, we may have deliberately paid a vendor early to get an increased credit line or kept expenses constant but not received a customer payment on time. These will impact cash flow for the related period.
Why is all of this important?
Depending on the size of your company and whether you are personally responsible for every expense in your business or not, you may not know day to day where your cash is going. You may not have eyes on all of the activities that are going on. Even if you are a one person show, it's hard to keep track of everything mentally and know what your bottom line looks like.
Making sure that all of the activities are recorded accurately in your software system is the first step in your financial road map.
The second step is analyzing the results. You do this by reviewing the Balance Sheet, Income Statement, and Statement of Cash Flows for each period.
-
How much cash did you collect?
-
How much cash do you have left?
-
Do you have enough cash to pay your bills?
-
Are your products profitable?
-
Are you controlling your operating costs over time?
-
What kind of financing options make sense based on the financial strength of your company?
You can answer all of these questions and more by understanding your financial statements. I'll be continuing this topic in future posts to help you dive deeper and learn more about the financial position of your company!
Ready to look at your numbers? Download our free guide to the most popular financial ratios here!