This month, we will explore three financial statements every business owner should understand.
They are :
- The balance sheet
- The income statement
- The cash flow statement
While we don’t recommend doing the books yourself unless you are bookkeeping professional, trying to run your business without understanding the balance sheet, income and cash flow statements is like driving a car without an engine. Understanding these concepts is key to planning for the future (forecasting), preparing taxes and managing your day-to-day operations. It is also critical, because investors might want to see these statements at a moment’s notice.
Let’s look into each of these financial reports in greater detail:
THE BALANCE SHEET
This is a snapshot of your company’s financial position at a particular point in time. Just like taking a family portrait every year and compiling a photo album, you can compare the “pictures” of your business, year to year to see how it has expanded or changed.
How is it calculated: The accounting equation forms the basis of double entry bookkeeping and has three components.
Assets = Liabilities + Equity
- Assets are resources owned by your business that can be measured and have value. Some examples include cash, accounts receivables, inventory, land and equipment. Assets also include prepaid rent.
- Think of Liabilities as the obligations of your business — amounts you owe to creditors. Liabilities usually have the word “payable” in their accounting entry. Some examples are: notes payable, accounts payable, interest payables and salary payable.
- Equity is what is left over when you subtract your liabilities from your assets. In other words, you would rearrange the equation as shown below:
Equity = Assets – Liabilities
Breaking down the balance sheet: The balance sheet gets its name from the fact that both sides of the Assets = Liabilities + Equity equation must balance out. According to Investopedia, “This is intuitive: a company has to pay for all the things it owns (assets) by either borrowing money (taking on liabilities) or [through equity investments].”
Here’s a simple example: If your business acquired $10,000 in inventory by taking out credit terms with a supplier, then your assets will increase by $10,000. However, your liabilities must also increase by $10,000.
Importance of the balance sheet: The balance sheet gives the reader insight into the organization’s financial health, as it details what a company owns against what it owes. This is valuable information for your own goal setting objectives as well as for potential investors. Bankers will also need to see your balance sheet if you are seeking a business loan.
THE INCOME STATEMENT
This key financial statement outlines your business’ profitability over a period of time (for example: a particular month, quarter or year). As such, the income statement is often referred to as the profit & loss (P&L) statement. It shows the revenue (sales of goods and services), minus the expenses your business incurred.
Components of the income statement:
- Income refers to all revenue earned by your business from your core operations as well as income from secondary activities like interest income.
- Cost of goods sold (also known as, COGS or cost of sales) includes all the costs related to the sale of products in your inventory. For a service-oriented business, this represents the cost of services rendered.
- Gross profit or gross profit margin is the difference between revenue and cost of goods sold. This is a key indicator of your business’ ability to cover the remaining expenses outside of the cost of goods sold. The higher this measure is, the better.
- Operating expenses are related to selling, general and administrative expenses. This line item includes overheads and salaries.
- Operating income is found by subtracting operating expenses from the gross profit margin.
- Depreciation reflects the decrease in value of assets like equipment which are used to generate income.
- Earnings before interest and taxes shows the ability of a business to repay its obligations.
- Interest refers to the cost of borrowing funds to finance the company’s assets.
- The line item for taxes reflects an estimate of what the business expects to pay to the IRS.
- Net income shows the company’s real bottom line. However, if the organization’s expenses exceed its income this will be recorded as a net loss.
Importance of the income statement: This statement shows you your taxable income. It is also important for investors to analyze the profitability and future growth prospects of your business.
THE CASH FLOW STATEMENT
We’ve saved the best for last. Cash flow refers to the movement of cash and cash-equivalents (short term, liquid assets such as treasury bills) into and out of a business. You might have heard the statement “cash is king”. At the end of the day, “profit” cannot satisfy a company’s current liabilities; only cash can.
Components of the cash flow statement:
- Operating cash flow – As the name suggests, this measures how much cash is generated from a business’ core operations.
- Investing cash flow – This generally refers to cash spent on assets such as equipment. However, when a company sells an asset, the proceeds would be recorded as a cash inflow.
- Financing cash flow – A company records a cash inflow when it raises money (for example from an investor). On the other hand, a cash outflow occurs when it pays a creditor, thus reducing cash.
Importance of the cash flow statement: The cash flow statement gives a true sense of your company’s ability to meet current expenses, pay down debt, reinvest into the business and prepare for milestone events. For more details on cash flow management, see our previous blog post.
Where do you go from here? All of these statements are important measures to evaluate the performance of your business year to year. The good news is that RQB is here to help ensure that you have up-to-date, accurate books that will allow you to make informed decisions — regardless of your business goals. Contact our team today.