Understanding, Creating, and Analyzing Your Financial Statements

What is a financial statement?

Financial statements are accounting documents that summarize your business’ activities and position. You’ll need them for processes like financial analysis, cash-flow forecasting, and tax planning. In addition, you’ll often need to provide your current and prior year financial statements to potential investors, creditors, or partners.

There are many different types of financial statements, but the three primary ones are the balance sheet, income statement, and statement of cash flows. Respectively, these documents capture a business’ financial position on a fixed date, profit or loss over time, and cash inflows and outflows over time.

What should go on your financial statements?

It’s always wise to hire a Certified Public Accountant (CPA) to double-check that your financial statements are accurate. However, you still need to know what they contain and how they work to build and analyze them.

Let’s review the accounts that go on each of the primary financial statements and explore the types of analysis you can perform on them.

The balance sheet.

Balance sheets present your business’ financial position at a fixed point in time. In other words, they give a snapshot of your assets, liabilities, and shareholders’ equity on a given date. The balance sheet revolves around the fundamental accounting equation: Assets = Liabilities + Shareholders’ Equity.

Let’s take a look at each of those terms in turn.

Assets

Assets are things of measurable monetary value that your business owns. Some examples are cash, accounts receivable, inventory, land, buildings, equipment, and goodwill. In addition, your assets may include costs you’ve paid in advance, such as prepaid insurance or rent.

You should sort your assets into two categories: current and non-current. Your current assets are those you expect to convert to cash within one year, like accounts receivable and inventory. Non-current assets are those you don’t expect to convert within a year, like buildings and equipment.

Liabilities

Liabilities are debts you owe to other parties, such as online lenders. Some common examples of liabilities include credit card balances, accounts payable, business loans, wages payable, customer deposits, and unearned revenues.

Like assets, liabilities are either current or non-current. Current liabilities are debts you expect to pay off within the year, while long-term liabilities are obligations that will remain outstanding for more than 12 months.

Equity

Shareholders’ equity is the money that would be left over if you sold all of your company’s assets and paid off its liabilities. The amount would usually include the money you contributed to your company to start the business plus any profits kept in the company from previous years, known as retained earnings.

Balance sheet analysis.

Balance sheet analysis lets you gauge the strength of your financial position to inform your business decisions. It often involves comparing your current and prior period numbers to assess your growth and calculating the ratios between your assets, liabilities, and equity.

For example, say you compare your current cash reserves to your prior year’s balance and find they’ve decreased by 20%. That makes you concerned about your liquidity, which refers to your ability to pay your debts over the upcoming year.

To further assess your liquidity risk, you calculate your current ratio, which tells you whether you could afford to pay your current debts if you converted your current assets to cash. The formula is: Current Ratio = Current Assets/Current Liabilities.

Unfortunately, yours is 0.85, indicating your cash and current assets cover 85% of your debts due next year. That means your risk of missing payments is relatively high, so you should cut your spending to help rebuild your cash reserves.

For more information on how to read a balance sheet, visit this post.

The income statement.

The income statement shows your business’s net income or loss over time. It’s primarily a tool for calculating and analyzing your profitability. The formula for the income statement is: Net Income = (Revenue – Expenses) + (Gains – Losses).

Let’s look at what these categories mean and some of the accounts that fall into them.

Revenues

Your revenue is the income your business generates through its primary operations. For example, a law practice’s revenues would be its earnings from providing legal services to clients. Some companies may also refer to the line item as sales, and it sits at the top of the income statement before all expenses.

There generally aren’t sub accounts within your revenues unless you have multiple operating segments that constitute separate income streams.

Expenses

Your expenses refer to the costs that your company incurs while doing business. The income statement separates them into two primary groups: the cost of goods sold (COGS) and operating expenses.

COGS refers to the spending necessary to get your products or services to market. It sits just below revenues on the income statement and includes direct labor, direct materials, and manufacturing overhead.

Operating expenses are the costs you incur in your day-to-day operations that aren’t directly related to your product or service. They go below COGS on the income statement and include a wider variety of costs, such as administrative salaries, office supplies, property taxes, rent, professional services, interest, and more.

Gains and losses

Your revenues and expenses dominate your income statement since you generate them through your business’ primary activities. Meanwhile, gains and losses come from activities other than your day-to-day operations and arise only occasionally.

Most often, you generate them when your business disposes of an asset. Gains occur when you sell something for more than its cost basis, your original purchase price minus any depreciation. Selling an asset for less than its cost basis generates a loss.

Gains and losses go just above your company’s net income, the last line of the income statement.

Income statement analysis.

Income statement analysis primarily helps you gain insight into your company’s profitability. Just like with balance sheets, that often involves calculating ratios between the various accounts presented.

For example, one popular ratio is the gross profit margin. Its formula is: Gross Profit Margin = (Revenues – Cost of Goods Sold)/Revenues. If yours is lower than your industry’s standard, you probably need to increase your prices or reduce your manufacturing costs to be as profitable as your competitors.

It’s also beneficial to analyze your income statement by comparing it to your prior period or budgeted results. The differences between them can reveal opportunities for improving your profitability.

For example, say you’re a general contractor whose quarterly labor costs are 10% higher than budgeted. Upon further investigation, you discover your electrical subcontractor has consistently taken 20% more hours than expected to complete the projects you’ve assigned, so you should decide to look for a new electrician.

For more information on how to read an income statement, visit this post.

Cash flow statement.

While an income statement shows whether your company made a profit, a cash flow statement displays whether your business generated or lost cash. It presents your cash inflows and outflows over time.

The statement separates your cash flows into the following three categories:

• Operating activities – Regular day-to-day business activities that generate cash inflows and outflows as you collect revenues and incur expenses
• Investing activities – Changes in cash from buying and selling property or long-term investments
• Financing activities – Cash changes from debt- and equity-related activities, such as borrowing money, servicing debt, or selling shares of stock.

For more information on how to read a cash flow statement, visit this post.

The three primary financial statements help you or any other interested party to understand and analyze your business’s financial position, profitability, and cash flows. Not only is that necessary for financial planning, but it’s also essential when applying for business financing.

References

1 U.S. Securities and Exchange Commission. (n.d.). Beginners’ Guide to Financial Statement. Retrieved August 30, 2018 from https://www.sec.gov/reportspubs/investor-publications/investorpubsbegfinstmtguidehtm.html

2 Schmidt, M. (March 5, 2018). Cash flow statements: Reviewing Cash Flow from Operations. Retrieved August 30, 2018 from https://www.investopedia.com/articles/investing/102413/cash-flow-statement-reviewing-cash-flow-operations.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186