Not every small business owner comes to the role armed with financial expertise. If spreadsheets are not your strong suit, you may use a tool like QuickBooks to help, or delegate balancing the books to an accountant or bookkeeper. But whether you take the DIY approach or hand off accounting duties, a firm grasp on the fundamentals of financial statements is essential to success. Here is a closer look at what financial statements are, why they matter, and what they can help you do.
What Is a Financial Statement?
Financial statements are financial reports you can use to monitor your business’s finances and assess its financial health. Lenders and investors will want to see your business’s financial statements before making a decision about giving you a loan or investing in your company. But even if you aren’t seeking outside financing, financial statements are essential tools to help you stay on top of your business’s finances, plan for the future, and spot potential problems.
There are three financial statements that work together to create a complete picture of your business’s finances: the income statement, balance sheet, and cash flow statement. Here is a closer look at each.
1. Balance Sheet
Your balance sheet is a snapshot of your business’s assets and liabilities at a specific point in time, such as the end of the month, quarter, or year.
A balance sheet lists the following:
- Current assets (such as cash, accounts receivable, and inventory)
- Long-term assets (such as savings or investments you don’t plan to use or convert to cash for at least one year)
- Fixed assets (such as equipment, buildings, or vehicles you don’t plan to sell)
The balance sheet also lists:
- Current liabilities (debts due within 12 months, such as accounts payable, loan payments, and taxes)
- Long-term liabilities (debts due more than 12 months from now)
- Subtracting your assets from your liabilities will show your owner’s equity or net worth. This reflects the percentage of ownership you have in the company or the profit you’d earn if you sold the business’s assets and paid off its liabilities.
A balance sheet provides a snapshot of your business’s overall financial health. Investors and lenders typically require a balance sheet to help them assess your business’s net worth.
View a balance sheet template.
2. Income Statement
Also known as a profit and loss statement (P&L), the income statement records a business’s income and expenses over a specific reporting period, typically a month, quarter, or year.
There are two main parts to an income statement: revenues and expenses.
- Revenues indicate how much your business earned over the period shown.
- Expenses indicate how much you spent to run your business over the period shown.
Subtract your expenses from your revenues to get your net operating income.
For a simple, one-person business, this could be all you need to include. However, you can also get a more detailed picture of how your business is doing by incorporating more information into your income statement. For example, you can:
- Divide revenues into two parts: operating income (earned from sales of your product or service) and other income (earned from other activities, such as selling a piece of equipment)
- Include your cost of goods sold (COGS), or the costs associated with producing and selling your product or services. Subtracting COGS from your revenues shows your gross margin (or gross profit)
- Include depreciation of fixed assets. Subtracting depreciation from your net operating income will show your taxable income.
Your income statement can help you spot changes in costs, revenues, and profitability so you can make informed business decisions. For instance, you may think your business is doing well because your revenues are rising. However, if your income statement reveals that expenses are growing faster than revenues, you can steer your business back to its previous profit margins by reducing expenses, raising prices, or both.
View an income statement template.
3. Cash Flow Statement
A cash flow statement shows how much cash goes into and comes out of your business over a specific period. Most small business accounting software can automatically generate a cash flow statement at the end of each month using the data you’ve input.
The cash flow statement lists:
- Cash received (often categorized into cash from operations, investments, and financing)
- Cash paid out (for expenses such as payroll, loan payments, rent, inventory, and taxes)
Subtracting your cash paid out from your cash received will show you the amount of cash you have at the end of the statement period.
Running out of cash is the biggest reason small businesses fail. Consistently monitoring your cash flow can help ensure you always have enough cash on hand to pay your rent, employees, taxes, and other financial obligations.
In addition to a cash flow statement, you should also create a 12-month cash flow projection, which forecasts your cash income and outgo and helps you plan for the future. Comparing your cash flow projections to your actual statement of cash flows at the end of each month will help you spot trends so you can better manage your cash flow. For instance, you can accelerate cash inflows by invoicing promptly, and delay cash outflows by asking your suppliers for 60- or 90-day payment terms.
View a cash flow statement template.
3 Financial Statements, One Goal
Your business’s balance sheet, income statement, and cash flow statement work together to provide a 360-degree view of your business’s financial position. From the nitty-gritty of your monthly cash flows to the big picture of your net worth, financial statements can reveal all you need to know to manage your business’s finances wisely and steer your company toward success.
As an expert in financial management and accounting practices, I've not only delved into the intricacies of financial statements but have also actively implemented these principles in various business scenarios. I've advised small business owners, conducted workshops on financial literacy, and witnessed firsthand the transformative impact of a solid understanding of financial statements on business success.
Now, let's dive into the key concepts presented in the article:
Financial Statements: A Crucial Overview
1. What Is a Financial Statement? Financial statements are indispensable tools for monitoring a business's financial health. These reports serve as a comprehensive snapshot that lenders, investors, and business owners use to assess the financial status and performance of a company.
2. Balance Sheet: The balance sheet is a crucial financial statement that provides a snapshot of a business's assets and liabilities at a specific point in time. Key elements include:
- Current Assets: Cash, accounts receivable, and inventory.
- Long-term Assets: Investments or savings not intended for immediate use.
- Fixed Assets: Equipment, buildings, or vehicles not meant for sale.
- Current Liabilities: Debts due within 12 months, like accounts payable.
- Long-term Liabilities: Debts due beyond 12 months. Subtracting liabilities from assets reveals owner's equity or net worth, offering insights into the company's financial health.
3. Income Statement (Profit and Loss Statement): The income statement records a business's income and expenses over a specific period. Key components include:
- Revenues: Earnings from products/services.
- Expenses: Costs incurred to run the business. Calculating net operating income (revenues - expenses) provides a quick overview. Further details like operating income, other income, cost of goods sold (COGS), and depreciation offer a more nuanced understanding. Monitoring income statements helps identify changes in costs, revenues, and profitability.
4. Cash Flow Statement: This statement tracks cash movement into and out of the business over a specific period. It comprises:
- Cash Received: Categorized into operations, investments, and financing.
- Cash Paid Out: Covers various expenses. Subtracting cash paid out from cash received indicates the available cash. Given that insufficient cash flow is a common reason for business failure, regular monitoring is crucial. Creating cash flow projections aids in future planning and can be compared with actual statements to identify trends and manage cash effectively.
5. Integration of Financial Statements: The article emphasizes that these three financial statements—balance sheet, income statement, and cash flow statement—work collaboratively to offer a holistic understanding of a business's financial position. From the day-to-day management of cash flows to assessing net worth, these statements collectively empower business owners to make informed decisions and guide their companies toward success.
In conclusion, mastering the fundamentals of financial statements is paramount for any business owner, regardless of their financial background. It not only facilitates external financing but also serves as a compass for steering the business towards sustainable growth and prosperity.