Financial Statements for Small Businesses Simplified [With FREE Templates]
According to a study, 93% of small business owners prepared their monthly financial statements (income statement and balance sheet), but 70% of them said they did not perform monthly financial analysis and had ZERO understanding of basic financial ratios. So if that’s you, you’re clearly not alone!
100% of small business owners with financial difficulties admitted they did not perform financial analysis on their monthly financial statements. So if this is also you, and you’re struggling to keep your business up and running, keep reading.
We get it. Financial statements can seem daunting for you as a small business owner, but understanding the key concepts is crucial to running a successful business. If you have a problem with reading and analyzing your financial statements, don’t worry. We’ve got you!
In this guide, we’ll explore what financial statements are, how to read and interpret them, and how you can use them to make informed decisions.
PREPARING YOUR FINANCIAL SOURCE DOCUMENTS
Before we dive into how to read your financial statements, first things first. What makes up your financial statements?
As a small business owner, your one main goal in performing bookkeeping and recordkeeping is to collect and organize your source documents. These source documents prove that a business transaction (or financial transactions) has happened. Some of these source documents may include but are not limited to the following:
- Credit memos.
- Employee time cards.
- Deposit slips.
- Purchase orders.
“Why should I keep them? Can I entrust this with my bookkeeper?” Answer: Yes and No.
Yes, you can entrust the organizing of source documents to your bookkeeper. And no, you cannot entrust it 100% to your bookkeeper. Have a system in place where you have a copy of all the source documents your bookkeeper has been organizing (just in case he/she resigns, you can easily turn this over to the next bookkeeper).
PRO TIP: Organizing your source documents will not just be for bookkeeping purposes. These can be of great use to your tax professional as well!
The source documents will then now be recorded, journalized, and summarized, which will form your financial statements.
And now, let’s skip to the good part – your financial statements. What are included in your financial statements?
THREE BASIC FINANCIAL STATEMENTS
To understand the components of a financial statement, check the illustration below, assuming the Apple tree is your business. Let’s get to know each element of your financial statements one by one:
An income statement measures the fruits of your business efforts in a certain period. It focuses on your business’s revenues and expenses during a specified period of time. You will know your net income/net loss by subtracting expenses from your revenues, resulting in a Net Income (or Loss). Think of this statement simplistically as telling you how much money you made, how much money you spent, and how much money you had left (if any) as a result.
Revenue or Sales (Line A) is what you earn from selling a product or a service. You can have one business with multiple sources of revenue.
COST OF GOODS SOLD
Whether you are selling goods, products, or services, you incur expenses to produce your products or deliver your services; those direct costs associated with production are your Cost of Goods Sold (COGS) (Line B). Also known as the cost of sales, cost of revenue, cost of service, or product cost.
Once you deduct your COGS from your revenue/sales, you get your GROSS PROFIT (Line C). Gross profit is how much money you’re left with after subtracting your COGS from how much money you generate in revenue.
You’ll use your gross profit to determine your gross margin.
OTHER OPERATING EXPENSES
There are other indirect expenses (not directly related to producing your product) that you incur to keep your business running that may not be directly tied to creating, making, or providing your product or service. For example, employee salaries, business place maintenance, insurance, utilities, advertising and marketing expenses, etc. These are your Other Operating Expenses (Line D)..
EBITDA (Earning Before Interest, Tax, Depreciation, Amortization)
Your EBITDA (Line E) is how much money you’re left with after subtracting out your COGS and Other Operating expenses from your revenue (how much money you made). Put a little differently, EBITDA is your earnings (how much money you’re left with) before you take into account any non-operating expenses such as interest, taxes, depreciation, or amortization.
These are expenses not directly tied to operating your business. It’s more about how you decided to fund your business. Examples of these expenses that form part of your non-operating expenses (Line F) are interest, taxes, depreciation, and amortization.
NET INCOME (LOSS)
Deduct these operating expenses, non-operating expenses, and taxes from your Gross Profit, and you’ll get your Net Income (Loss) (Line G). Net income is also known as your bottom line.
If your REVENUES exceed your EXPENSES, you’ll get Net Income or Net Profit or Positive Bottom Line. If your expenses outweigh your revenues, you’ll incur a Net Loss.
At the end of each year, net income is added to your Retained Earnings seen on your Balance Sheet – Equity Section).
Small businesses may incur losses for many reason, from low sales, mismanaged expenses, to the mispricing of your products or services (Check this podcast to know how to price your products or services correctly.) To avoid this, have a detailed Income Statement, categorize expenses in the correct bucket so you can properly analyze your results, and know the value of your product and services. Your main goal is to have a better understanding of where you need to improve and increase your margins.
CASH FLOW STATEMENT
The cash flow statement shows where the cash went and where you obtained the cash from (sources of cash). The cash movements in your business will be related to either operating, investing, or financing activities.
- Operating activities – arise from the activities a business uses to produce net income.
Examples: purchase inventory, cash from sales, income tax
- Investing activities – cash business transactions related to a business’s long-term investments
Examples: purchase or sale of land, building, equipment (Fixed Assets)
- Financing activities – cash transactions related to the business raising money from equity or debt, or repaying that debt.
Examples: cash payments made on a loan (principle) and cash proceeds received from notes
Business liquidity is often more important than profitability. Even if your business makes profits but you don’t have sufficient cash on hand, you could struggle to fund your business’ ongoing operations. (getting short on cash on hand? Check here for ways how to fund your start-up.) Keeping your cash flows positive can help your business save financing costs and ensure the continuation of smooth business operations. As a business owner, you want to have a grasp on where your money is going so that you can make strategic decisions. (Check here for tips on managing your cash flows)
The balance sheet is often referred to as understanding the true health of your company because it gives you a snapshot of where you stand with cash, how you’ve performed over time (your retained earnings), how you funded your business (debt and equity), and so much more. It is the connection between your income statement and cash flow statement.
Assets (Line A) are any resources owned and controlled by your business. In short, assets are something you own, like cash, inventories, properties, and vehicles. Liabilities (Line B) are your business obligations that must be paid in the future due to a past transaction or other past events, like accounts payable, salaries payable, notes payable, and unearned income.
Assets and liabilities can either be CURRENT or NON-CURRENT.
Owner’s Equity (Line C) is your business’s total assets less the liabilities. This amount is your net value; tangibly, think of it as if all your assets are liquidated (cashed out), and all liabilities and obligations were paid off and settled; this is the amount you would be left with, your “equity.”
> Retained Earnings make up part of your Owner’s Equity and reflect the cumulative amount of net income(or losses) that were not paid out to shareholders or withdrawn. Retained Earnings can be held onto to use for whatever a business decides to use it on at some future time, reinvested for future development, used for liability settlement, invested, or used for expansion. As the business (along with potential approval from your Board of Directors, if you have them), you can decide to distribute a portion of retained earnings; this is called Dividends. As a small business owner, you can also think of dividends as a “bonus payout.”
Financial statements have different elements that provide key information about the health of a business. The most common financial statements are the balance sheet, income statement, and statement of cash flows. Each statement has different components that measure aspects such as assets, liabilities, net worth, revenues, and expenses. Understanding these key components will help you analyze each statement and make better-informed financial and overall business decisions.
To ensure that your financial data and financial statements are accurately presented and analyzed for you, your investors, and your internal stakeholders, ask for help here!
BONUS: Familiarizing yourself with financial statements is just the start. You still need to do the reading, interpreting, and analyzing of your financial statements! What are the numbers telling you and your business? Download our most-downloaded freebie here to know the common financial terms every business owner like you needs to know!