A Complete Guide to Reading Financial Statements
You’ve been in business for a while, and your next steps require you to obtain a small business loan. Your lender responds to your request favorably but asks to see your company’s recent balance sheet.
With little experience in reading financial statements, this request makes you freeze in your tracks, uncertain of how to express the success of your growing business.
If this scenario sounds in any way relatable, it’s time to become more familiar with the process of reading financial statements. The better you understand these documents, the better you’ll understand your business. We’ll help you learn to read and interpret your financial statements and show you how they impact your company.
What Financial Statements Are
If knowledge is power, then the strength of your small business lies in your ability to generate and analyze financial reports. Think of these documents as the “report card” for your company.
That analogy might conjure up some unpleasant memories for some, but the point is simple: just as a report card shows areas of strength and weakness, your financial statements show areas where your business is thriving, as well as highlight areas that could use some attention.
Your financial statements, therefore, contain valuable information about your company’s financial health. You can use this information to learn from the past and devise a strategy for your company’s future.
What sort of business financial statements will you be expected to read as a business owner? Typically, your company will rely on three basic types of financial statements. These are:
- Balance sheets
- Income statements (also called “profit and loss statements”)
- Cash flow statements
Each of these documents describes your company’s finances, just through a different lens. The process of reading financial statements can help you better understand where your money came from, how much money you have at the moment, and any liabilities you have moving forward.
Why Leveraging Understanding of Financial Statements Is Important
While accountants and financial professionals use these statements all of the time, small business owners need to be familiar with the core documents that govern their finances.
In this article, we’ll provide a beginner’s guide to reading financial statements. We’ll cover the three main documents you should be familiar with and touch briefly on shareholder reporting.
Your company’s balance sheet is one of the most basic and comprehensive financial statements you’ll be reading. Accounting software will set up a balance sheet according to the following equation:
Assets = Liabilities + Shareholders’ Equity
Typically, your company’s assets will be listed on the left side of the balance sheet, while liabilities and the shareholders’ equity will be listed on the right. However, it’s not unusual for some companies to list these categories from top to bottom. Let’s explore each of these three elements in greater detail.
Assets refer broadly to anything your company owns. Assets include your company’s money, as well as anything you own that can be sold or converted into cash. Naturally, this includes cash and extends to various types of physical and even non-physical property. Assets can include such items as:
- Physical property/retail space
- Product inventory
- Commercial vehicles
- Business investments
Assets can be further broken down into current and noncurrent assets. Current assets include anything that your company can convert to cash within a year.
Non-current assets refer to items that a company does not anticipate converting to cash. This category would include “fixed” assets, which are those things needed to run the business.
Liabilities, by contrast, refers to money your company owes to others. This category contains financial obligations that include:
- Money borrowed from a bank
- Rent owed for the use of a building or commercial space
- Money owed to vendors for supplies and materials
- Payroll money owed to employees
- Costs for environmental cleanup projects
- Any obligations to provide products or services for customers.
Liabilities can also be broken down into current and long-term liabilities. Current liabilities generally refer to money owed within the year, while long-term liabilities refer to money owed over longer periods.
The difference between a company’s assets and liabilities is referred to as the shareholders’ equity, sometimes called the “book value” or simply the net worth.
Thus, your balance sheet forms a comprehensive snapshot of your company’s finances at any given point in time. When reading financial statements, you’ll likely start with your balance sheet and then turn to other sources of information for more detailed reporting data.
An Income statement (also known as a “profit and loss statement”) records the impact of revenue, financial loss, and business expenses over a given period. While this period is often a year or a full quarter, larger enterprises might regularly generate them to keep ahead of any noticeable trends.
Your income sheet is commonly included as part of a quarterly or annual business report and has two general uses. First, an income statement can be used to evaluate your company’s overall profitability and may highlight areas for improvement, such as areas where you should minimize overhead costs for the sake of the business.
Secondly, income statements can help identify financial trends. For instance, there may be periods of seasonal demand for certain products and services, which can be planned for in the future to capitalize on these financial patterns.
When reading financial statements of this type, it’s extremely important to understand both the structure of the document and its vocabulary. At the top of your income sheet, you’ll find the total sales revenue made during a given accounting period, let’s say a year.
Then you go down the sheet, making deductions for each item on your list. At the bottom of the sheet, you’ll find the final amount that your company earned (or lost) during this period.
Yes, this final figure is known as the “bottom line.” But if you want to change this last figure, you’ll have to understand the types of deductions that you’ll find between your gross and net profits. Understanding your income statements will require you to understand the following key terms:
- Revenue: How much money your company has received
- Expenses: How much money your company has spent
- Cost of Goods Sold (COGS): How much it costs to make your products
- Gross Profit: Total revenue minus COGS
- Operating Income: Gross profit minus operating expenses
- Income Before Taxes: Operating income minus non-operating expenses
- Net Income: Your pre-tax income, minus the amount paid in taxes
- Earnings Per Share (EPS): Your net income divided by the total number of shares
- Depreciation: How much value your assets have lost over time
- EBITDA: Earnings before interest, taxes, depreciation, and amortization
If this list seems overwhelming, just look closer. You’ll see how most of these terms simply depend on one another.
For example, calculating your gross profit will allow you to calculate your operating income, which will let you calculate your income before taxes, which you will then use to determine your net income.
In other words, as you work your way through your income statement, each step builds on the one that precedes it until you finally arrive at your bottom line.
Once you gain more experience with reading financial statements, you’ll appreciate this level of detail. Your income statements will reveal how each line item described above directly impacts the overall profitability of your business and will also highlight ways in which you can refine your business processes to minimize loss and drive revenue.
Cash Flow Statements
Cash flow statements record the movement of cash in and out of your company. This recording is a bit different from your income statement, which illustrates total profitability.
Your cash flow statement describes how much actual money your company has to work with, cash that you can need for purchasing new assets, making new investments, or simply paying the bills.
There are three distinct sections of your cash flow statement, based on the type of financial activity that it describes:
- Operating activities
- Investing activities
- Financing activities
Understanding each of these sections will help you understand your cash flow statement as a whole.
Your operating activities refer to your cash flow resulting from net income or loss. Accounting for operating activities will require you to reconcile your company’s net income with the actual cash you either received or used during your operating period.
This calculation means that your cash flow statement will need to adjust your net income for non-cash items such as depreciation and other expenses, as well as record any cash used for other operating expenses or liabilities.
The result shows the movement of cash within your company during the specified period. Most software can generate cash flow statements for any given period, though they are typically prepared either quarterly or annually.
Next, your cash flow statement records the cash movement associated with investing activities.
This calculation generally means two things. First, it can mean purchasing long-term assets, which include property, equipment, inventory, or the purchase of securities. You would record all of these purchases on the cash flow statement to represent cash leaving the hands of a company.
Second, it can reflect a company selling any of these assets. Again, your company’s assets include anything that you can convert into cash. When this happens, your cash flow statement will record the change in the section on investing activities.
Finally, your cash flow statement will include cash flow based on financing activities. What types of activities does this include? This section can include selling your company’s own stocks or securities or borrowing from banks and other financial institutions.
These activities are recorded as cash flowing either into or out of your company. For example, when you pay back a loan, it would be recorded here as the use of cash flow.
How Your Books Influence Your Financial Statements
Earlier, we compared your financial statements to a report card. But the reporting data will be meaningless if it’s not up-to-date and accurate. Yet because many business owners have to juggle multiple responsibilities, it’s easy to fall a little behind.
Getting caught up in your bookkeeping is the first step. Having accurate, up-to-date books will ensure that you’re able to generate meaningful financial statements. Using caught up books will let you create each of these types of reports with precision and pinpoint accuracy.
Remember, the financial reports we’ve discussed aren’t just important for evaluating your company’s past; they can be useful for drawing a roadmap for your company’s future. You should use only the best and most reliable data for generating these reports, which can then be used to refine your strategy moving forward.
Otherwise, you’re going to be faced with quite a few headaches. Not only will you be unable to assess the financial strength of your company, but your lack of reliable reports will jeopardize your eligibility for small business loans.
If you don’t get your books caught up by tax season, you could find yourself faced with additional tax penalties for failing to accurately report income. For this reason, many business owners discover that reading financial statements becomes a lot more reliable when they outsource their financial processes to an online firm.
Relying on a team of experts can ensure that your books are up-to-date, accurate, and can be used to generate the kinds of reports you need to make informed business decisions.
Better Reporting, Better Business
Reading financial statements gets easier with time and experience. Soon enough, you’ll wonder how your business ever survived without these important documents. You’ll also wonder how you can improve the accuracy and immediacy of your reporting procedures.
The answer is to partner with one of the best accounting firms in the industry. Xendoo can help you catch up on your books, provide ongoing accounting services, and even provide access to advanced reporting features, so you always stay in the loop regarding your company’s financial performance.
See for yourself by signing up for our no-obligation free trial. You’ll get access to the features that can take your business from good to great and improve your trajectory for the future.