The 3 Financial Statements Small Business Owners Must Understand

financial reports for small business owners

This month’s article series focuses on essential finance skills for small business owners. In this first article, we review the three financial statements every small business owner must understand.

Let’s start with the basics…

What are Financial Statements, and Why Are They Important?

Financial statements (or financial reports) are formal records of the financial activities and position of a business, person, or other entity.” (https://en.wikipedia.org/wiki/Financial_statement)

Financial statements are reports that document the financial performance of a business. They are required annually for tax and other government compliance purposes but are generally prepared more regularly, such as quarterly or monthly.

Banks who provide funding, along with investors and creditors, often require access to the financial reports of a business.

Financial statements are essential for several reasons:

First and foremost, they are an indispensable tool for the organization’s management as they provide a comprehensive overview of the business’s financial performance and health. Accordingly, they can assist management in making decisions regarding upcoming investments, cost-cutting initiatives, and other strategic choices.
They offer crucial information to creditors and investors debating whether to lend the company money. They use financial reports to assess the company’s financial health and decide whether to invest or lend.
Regulatory bodies often require financial statements. This may depend on the type of business you are in and your structure, but at the very least, you will have federal, state and even local tax obligations. Therefore, staying legally compliant is an integral part of business management.

The three primary financial statements a small business owner needs to understand

1. Income statement

This document details earnings and expenses over a given time frame and indicates the business’s profitability during that period. It can also be called a Profit & Loss Statement, Earnings Statement, or Statement of Operations.

Importance of an Income Statement for a Small Business

income statement benefits

Aids in evaluating a business’s overall performance.

The income statement details a business’s income, costs, and expenses for a specific time period, enabling owners to monitor their progress and make wise decisions.

Assists in identifying where profitability can be improved.

By analyzing expenses and sources of income, better decisions can be made about where to allocate resources, cut costs and invest more.

Evaluates financial performance over time.

An income statement compares historical changes in financial performance. Monitoring changes over time helps identify areas for improvement.

Understanding your Income (Profit & Loss) Statement

Here are the components of an Income Statement:

P&L statement components

Revenue

Revenue (or Sales) is the business’s total money from selling goods or services.

Cost of Goods Sold (COGS)

Cost of goods sold (COGS) is the direct cost of producing goods or services a business sells. The cost of goods sold includes products purchased for resale. In a manufacturing business, it consists of the cost of raw materials, direct labor, and any other direct costs incurred in producing goods or services.

Gross Profit

Gross Profit is calculated by subtracting the cost of goods sold from the total revenue.

Operating Expenses

Operating expenses occur through normal business operations. They can include bank fees, insurance, rent, payroll, etc.

Depreciation and Amortization

Depreciation is an accounting method that apportions the cost of a long-term asset over its useful life. For instance, if you spend $10,000 on a piece of equipment, instead of deducting the full $10,000 in the year of purchase, you would apportion it over the course of its useful life, which may be several years.

An example is buying a piece of equipment for $10,000 that has a five-year usable life and a $2000 salvage value. To calculate the annual depreciation expense, you would subtract the salvage value from the cost of the asset ($10,000 – $2,000 = $8,000) and then divide that by the useful life of the asset ($8,000 / 5 = $1,600). This means you could record $1,600 in depreciation expense each year for the next five years.

By recording depreciation, you are spreading out the asset’s cost over its useful life and matching it to the revenues that the asset helps generate over that time. This helps to ensure that your financial statements accurately reflect the actual value of your business’s assets and expenses over time.

Interest Expense

Interest expense is the total interest paid to banks or creditors during the reporting period.

Taxes

Taxes are payments to the government according to the laws where your business is located and can include income, sales, property, and employment taxes.

Net Profit (Loss)

Your net profit (or loss) is derived by deducting all your expenses from total revenue. If the result is positive, it’s called net profit, and if it’s negative (in other words, if your total expenses are higher than your total revenue), it’s a net loss.

2. Balance Sheet

A Balance Sheet gives a quick overview of the business’s financial situation by summarizing its assets, liabilities and owner’s equity at a particular time. In addition, it offers crucial details on the solvency and liquidity of the business.

A Balance sheet follows a simple accounting formula that is:

Owner’s Equity = Assets – Liabilities

Assets are the things a business owns. Liabilities are amounts a company owes. After deducting what a business owes (its liabilities) from what it owns (its assets), the resulting value is the owner’s equity.

Importance of Having a Balance Sheet for Small Businesses

balance sheet

Provides an indication of net worth.

The net worth of a business can be gauged by comparing the total assets to the total liabilities. The net worth is positive if its assets exceed its liabilities and vice versa.

An analysis of specific types of assets or liabilities provides further insight into the liquidity and risk profile of the business.

Identify the availability of credit and cash.

The Balance Sheet identifies ‘current assets’ – assets you anticipate turning into cash within a year, separately from ‘non-current assets. Consequently, the current assets indicate the amount of money and credit available to the business.

Aids in securing funding from lenders.

Banks and lenders begin with the balance sheet to determine risk levels when providing funding. For example, lenders might view a company as a lower-risk investment if it has a positive net worth and enough liquidity (current assets exceed current liabilities).

Aids in decision making.

A balance sheet can also assist in making decisions around investing in new equipment or securing additional funding for growth.

Understanding your Balance Sheet

Here are the components of a Balance Sheet:

Assets

Assets are items that you own. They are dissected into current and non-current assets based on the time frame to turn them into cash.

Current Assets

Current assets are items your business owns that you can convert into cash within one year. These are the assets you can quickly turn into money, such as:

Cash and cash equivalents: Includes cash, coins, checks, and unrestricted bank accounts
Inventory: Physical products that are ready for sale, in-process, as well as raw materials.
Account receivables: Short-term amounts owed to your business by customers to whom you have sold goods or services on credit.

Non-Current Assets

Non-current assets, also known as fixed or long-term assets, are items you own that are not easily converted into cash. They include:

Tangible assets: Items like furniture, machinery, equipment and property
Intangible assets: Items such as patents and copyrights that aren’t physical by nature

Liabilities

Liabilities are what a business owes to others. There are two types of liabilities:

Current liabilities: Obligations such as accounts payable, short-term loans, and taxes projected to be settled within a year.
Long-term liabilities: Examples of long-term liabilities include long-term loans, bonds payable, and leases that are not anticipated to be settled within a year.

Owner’s Equity

Owners’ equity is a gauge of how much a company is worth to its owners. It indicates the sum of money that would remain after the business sold all of its assets and settled all of its liabilities.

Owners’ equity can be raised in a number of ways, including through the owners’ personal investments, business revenues, or debt repayment. On the other hand, it can be reduced by losses, taking on more debt, or the company suffering a loss.

3. Cash flow Statement

The Cash Flow Statement reports on the total ‘cash’ that passed through the business during the reporting period. It aids in figuring out the company’s capacity to generate cash, pay its debts, and make investments in future expansion.

Importance of a Cash Flow Statement for a Small Business

Benefits of a cash flow statement

Track how much money is flowing in and out of your business

By keeping an eye on your cash flow, you can better manage your liquidity by making sure you have enough cash on hand to cover your expenses.

Promotes better financial management

The Cash Flow Report helps identify areas where your financial management needs to be strengthened. For instance, if you notice that you have a lot of unpaid invoices, you may decide to create a more efficient invoicing system in order to improve cash flow.

Understanding your Cash Flow Statement

A Cash Flow Statement has several sections:

cash flow report sections

Operating activities: provides an overview of the company’s operations. It includes the net income, adjustments to operating assets and liabilities, and non-cash components like depreciation and amortization.
Investing activities: highlights how the business invests in capital expenditure and other investments.
Financial activities: describes financial activities including how money is raised and spent.
Net cash flow and ending cash balance: provides a summary of the total cash flow during the reporting period as well as the finishing cash balance.

In conclusion, having a good understanding of financial statements is essential for small business owners. The statements discussed in this article provide a wealth of information that can help business owners make informed decisions and take advantage of growth opportunities. Knowing the different parts of each statement is key to being able to interpret the numbers and use them to evaluate performance.

This is the final article in this month’s series on essentail small business finance skills. Other articles in this series include:

Analyze Financial Statements: Know Your Numbers
Understanding and Managing Small Business Cash Flow
How to Hire a Bookkeeper

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