How to Read Financial Statements for Business Owners
As a small business owner, you have financial transactions in the form of receipts – money incoming from customers, invoices you have to pay, and other expenses to operate your business, and other transactions potentially related to financing or receiving the money to fund your thriving business needs. Seeing the customers or orders come and go is not a good metric to see if your business is doing OK or not. You need to see your financial records as an assurance of the true health of your business so you can decide how to align your current condition with your established financial goal. (No established financial goal? Worry no more! Check this link to create a customized financial plan for your business.)
Your financial transactions will be summarized and prepared in the form of Financial Statements. You check the Financial Statements for key insights such as to know if you are earning or not for a period of time, how much is your company’s net worth (valuation), and where did your money go during the period?
These may be confusing at first but don’t worry, let’s check them out below, familiarize yourself with them and you will know them by heart before you know it!
- Income Statement – 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.
- Balance Sheet – shows an overview of your business’s assets, liabilities, and equity at a particular point in time. This view is key to knowing your net worth (valuation) and the true health of your business.
- Statement of Cash Flows – measures how well a company generates cash to pay its debts, expenses, and other obligations. You’ve likely heard us say it before, but we’ll say it again… ”CASH IS QUEEN”. Your cash is the heartbeat of your business…run out, and you could be in big trouble.
And to understand this fully, let us illustrate using a tree with the following highlighted parts:
- FRUITS (Income Statement).
You can see in the Income Statement how well your business is doing by knowing how much Net Profit you have in a certain period of time. Whether you were fruitful for that period or not.
- ROOTS (Balance Sheet)
The roots are the foundation of a tree. You need to plan well where to plant the tree and the frequencies to be watered depending on the tree you have. The same goes for your balance sheet. You need to plan ahead what is your financial goal and your strategies to achieve it (such as financing needs from debt or equity)
- WATER (Cash Flow)
In a business, you need to know where your money goes and if it is worth it for your business. Analyzing the cash flow of your company lets you analyze how much money was consumed by the Income Statement, and the Balance Sheet. In this way, you can adjust them accordingly to have a fruitful tree/business.
An income statement measures the fruits of your business efforts in a certain period. Your expenses will be deducted from your revenue, which will result in a Net Income (Profit/Loss). At the end of each year, net income is added to your Retained Earnings seen on your Balance Sheet.
Revenue/Sales is what you earn from selling a product or a service.
If you are selling a product, you incur expenses to produce these products; those direct costs associated with production are your Cost of Goods Sold (COGS).
Once you deduct your COGS from your revenue/sales, you get your GROSS PROFIT. You’ll use your gross profit to determine your gross margin (% form of what you have left in gross profit compared to how much you initially made in sales).
There are other indirect expenses (not directly related to producing your product) that you incur to keep your business running. For example, employee salaries, business place maintenance, insurance, utilities, advertising and marketing expenses, and so on. These are your Operating Expenses.
Operating expenses are fixed in nature, regardless of how much you sell or produce, these are going to incur. Oftentimes in your business, you will need to incur these indirect expenses, which you will also hear called overhead expenses.
If your business owes any loans and pays interest, then interest is also deducted from your Gross Profit. We refer to an interest expense as a non-operating expense because it isn’t directly tied to operating your business, it’s more about how you decided to fund your business.
This may not happen frequently in your business, but from time to time your businesses may sell assets, or settle liabilities. All the gains or losses arising from these activities are taken into account by showing up on your income statement as a non-operating expense (or gain) and finally gives your INCOME before taxes.
The taxes you owe all depend on your income before taxes, business structure, tax deductions, and a well-experienced tax accountant :).
Deduct these operating expenses, non-operating expenses, and taxes from your Gross Profit, and you’ll get your Net Income (Loss).
If your REVENUES exceed your EXPENSES, you’ll get Net Profit (Income). If your expenses outweigh your revenues, you’ll incur a Net Loss.
Many small business owners struggle with product pricing strategies. One of the main reasons for that is they do not break down the expenses to their rightful categories – COGS and other operating expenses.
Once you break down all of your expenses into their right buckets, you’ll have a better understanding of where you need to improve and increase your margins. (Check this post to know if you are pricing your products or services correctly.)
In the simplest term, a balance sheet measures what you own (assets), and what you owe (liability). The balance sheet is often referred to understand 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, and so much more. It is the connection between your income statement and cash flow statement.
Assets are any resources owned and controlled by your business. In short, assets are something you own, like cash, inventories, properties, vehicles. Liabilities are your business’s obligations that must be paid in the future as a result of a past transaction or other past events, like accounts payable, salaries payable, notes payable, unearned income.
Assets and liabilities can either be CURRENT or NON-CURRENT.
Owner’s Equity is your business’s total assets less the liabilities. This amount is your net money in case your assets are liquidated and all liabilities and obligations have been paid off and settled.
> Retained Earnings are part of the Shareholders’ Equity and reflect the cumulative amount of net income(or losses) that were not paid out to shareholders. 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 (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.”
Back to our tree analogy, a tree cannot bear fruit without the support of a strong trunk. In which case, a business cannot produce strong profits without a healthy Balance Sheet.
CASH FLOW STATEMENT
Business liquidity is often more important than profitability. Even if your business makes profits, but you don’t have cash in hand, you’ll struggle to fund business operations. (Check here for ways how to fund your start-up business.) The cash flow statement shows where the water (cash) went in your business. Keeping the cash flows positive can help your business save financing costs and smooth business operations. The cash movements in your business are going to either be related to operating, investing, and 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’ long-term investments
Examples: purchase or sale of land, building, equipment (Fixed Assets)
- Financing activities – cash transactions related to the business raising money from debt, or
repaying that debt.
Examples: cash payments for dividend distribution, cash proceeds from the issuance of notes payable
(Check here for tips on how to manage your cash flows.). As a business owner, you want to have a grasp on where your money is going so that you can make strategic decisions.
Understanding how to read financial statements is a small step to a bigger impact on your business. Once you familiarize these 3 financial statements and what they’re telling you, you can now analyze and interpret them, which is a very important part of preparing, planning, and aligning your financial plan and strategy.
Practice makes perfect, so to practice how to prepare a financial statement and interpret the results, check out the worksheet below and get started.