Although you may be familiar with the various financial statements that are presented to a business owner, you may need help to interpret them correctly. This guide will provide you with the necessary information to make informed decisions. Financial statements are composed of various components such as the income statement, cash flow statement, and balance sheet.
The Income Statement
An income statement shows a company’s income, expenses, and net income for a specific period. It’s important to note that the amount of money the business makes and spends during a specific period is shown. When reading an income statement, look at the revenue or sales section. This will show how much your business makes from selling products or services. Next, look at the cost of goods sold section, which shows the expenses directly related to producing the products or services sold. The difference of revenue and cost of goods sold is the gross profit.
After gross profit, the income statement will show operating expenses. These expenses can include rent, utilities, salaries, and marketing expenses. The difference between gross profit and operating expenses is the operating income or loss. Lastly, the income statement will show non-operating income and expenses, such as interest income and taxes, ultimately leading to the net income or loss for the period.
The Balance Sheet
The balance sheet provides a snapshot of a business’s financial position at a certain point in time. It shows what your company owns, owes, and what is left over for the owners or shareholders.
When reading a balance sheet, start with the assets section, which shows what your business owns, such as cash, accounts receivable, inventory, and equipment. Next, look at the liabilities section, which shows what your business owes, such as loans, accounts payable, and taxes owed. The equity section shows the difference between assets and liabilities, which shows what is left over for the owners or shareholders.
The equity section is further broken down into two parts: contributed capital, the money invested by the owners or shareholders, and retained earnings, which is the money earned and reinvested by the business.
The Cash Flow Statement
Inflows and cash outflows for a particular time are documented in a cash flow statement. The specific time reflected in a cash flow statement is typically a month, quarter, or year. It shows how much cash your business generated from operations, investing, and financing activities.
When reading a cash flow statement, start with the operating activities section. This section will outline the cash inflows and outflows related to the day-to-day operations of your business. Next, look at the investing activities section, which shows the cash inflows and outflows associated with buying and selling assets, such as equipment or real estate. Lastly, look at the financing activities section, which shows the cash inflows and outflows in conjunction with borrowing or repaying loans, issuing or buying back shares, and paying dividends.
Tips for Reading Financial Statements
- Look for trends over time. By comparing financial statements from different periods, you can see how your business performs and identify improvement areas.
- Pay attention to ratios. Ratios, such as the debt-to-equity ratio and the gross profit margin, can provide valuable insights into the financial health of your business.
- Feel free to ask for help. If you need help reading or interpreting financial statements, consider hiring a financial professional or consulting with a mentor or advisor.
Understanding how to read and interpret financial statements is essential for small business owners. By understanding the income statement, balance sheet, and cash flow statement, you can gain valuable insights into the financial health of your business and make informed decisions about its future. It’s essential to look for trends over time, pay attention to ratios, and seek help when needed. Remember that financial statements are just one tool in your financial management toolbox and should be used with other financial management strategies, such as budgeting and forecasting.