Financial statements are a pillar of accounting. They reflect the financial performance of your business and allow you to understand your normal business operations from a fiscal perspective. Financial statements help business owners make smart business decisions, get a loan, or convince investors to contribute to their organization’s capital. But only if they are accurate, precise, and tell the complete financial story of the company!
While you can hire accounting firms to deal with taxes, financial analyses, and revenue and expenses, it is critical for you to learn how to read financial statements and understand the financial picture they illustrate. Business owners who understand accounting principles and are familiarized with financial reports will find it easier to make strategic decisions for the growth of their business.
What are financial statements?
Financial statements are reports that compile and reflect financial accounting information regarding your business. They provide an accurate picture of your organization’s financial state and allow you to identify potential financial issues and risks. Furthermore, financial statements reflect your company’s financial health, including current assets and current liabilities, and give you the necessary figures to make informed decisions and steer the financial course of your business towards profitability.
Despite what many think, financial statements are not rocket science. They just require the willingness to learn basic accounting and assimilate a few accounting skills. There are three core financial statements that can reveal the complete story behind your company’s financial state:
- Income statement
- Balance sheet
- Cash flow statement
Each of the statements above is intricately linked to the others which means you need to have a solid understanding of all three to better comprehend your business finances.
The income statement
If you are planning to attract capital from an investor, it is good to know that the first financial statement they will analyze is your company’s income statement. An income statement illustrates the performance of your business with a focus on sales revenue over a specific time period. However, it also presents the costs and expenses associated with the respective revenues.
An income statement shows the organization’s net earnings or losses. The income statement is used to deduct the cost of goods sold (COGS) to determine the company’s gross profit – the profitability rate of your products. Subtracting operating expenses, interest, and income tax expenses by using accounting methods like matching and accruals, the income statement assesses the organization’s profitability and delivers its net income over a period of time.
Income statements also include earnings per share (EPS) allowing shareholders to know roughly how much money they are to receive if the company distributes its net earnings for the specified period. However, this is rarely the case, since companies usually reinvest much of their earnings. In the end, what most concerns someone who reads an income statement is if the company has made a profit or lost money during the specific accounting period. And this can easily be seen on the bottom line of the statement under net profit, net income, or net earnings.
The balance sheet
The balance sheet provides insight into a company’s assets, liabilities, and shareholder’s equity. It reflects the current financial state of an organization providing details about what your company owns and what it owes, at a given point in time.
Assets – items with value a company owns and can sell if need be – equipment, trucks, inventory, etc., as well as things with value that can’t be sold – trademarks and patents. Cash too is considered an asset, and so are investments.
Liabilities – debts your business owes to other people – bank loans, rent, money owed for supplies, the company’s payroll, or taxes. They can also include credit card debt and mortgages.
Shareholder’s equity – refers to the remaining value of a company after the company sells its assets and covers its liabilities. Shareholder’s equity belongs to shareholders or the company’s owners.
In other words, a balance sheet is a snapshot in time of a company’s financial health at the end of the reporting period. The reporting period may differ depending on the type of business you run. Some companies prefer a daily or monthly balance sheet, while others are fine with just a yearly balance sheet. It is important to remember though that a balance sheet doesn’t reveal the flows into and out of the company’s accounts during the respective period but only at a specified point in time.
The cash flow statement
As the name suggests, cash flow statements present the company’s inflows and outflows of cash. A statement of cash flow shows how much money has entered and left your business over a period of time. Your accountant prepares the cash flow statement using the accrual accounting method to also include revenue not yet received and expenses not yet paid.
When you read a statement of cash flow, you learn if the company has generated cash and how much cash has been paid out over a period of time. This can help you predict cash surpluses and shortages in the future. While the income statement presents the net income, a cash flow statement shows the increases or decreases in cash over a period of time and illustrates cash movements. A cash flow statement includes data about three activities:
Operating activities – shows what your business makes and spends when performing its normal business operations. The cash flow from operations reconciles the net income to the cash received or used when conducting its core business activities.
Investing activities – reports the cash flow derived from investing activities, such as asset purchases or sales, and investment securities. Purchases – like the purchase of equipment – are reflected as outflow cash while the proceeds from sales of investments from an investment portfolio would be considered cash inflow.
Financing activities – reflects the cash flow from activities like selling stocks or bonds or making a bank loan. This section also includes the money invested in the business, as well as the money taken to pay loans.
Knowing how to read financial statements and understanding the information each section reveals will help you optimize your financial performance and grow your business. Financial statements generate information regarding net income, cash flows, financial trends, and indicate the path to follow if you want to invest in assets and secure a loan. Moreover, they can help you do your taxes and benefit from tax deductions.
However, if this all seems like too much, don’t worry, many business owners often find themselves in your position. It’s for this reason that more than 1/3 of small businesses have outsourced their accounting. You can always rely on the help of an accounting professional who is going to guide you through the complex universe of accounting.