Managing a business well requires insight into your financial situation. Yet, it’s hard to have a clear understanding of where your company stands unless you know how to read the financial statements you receive from your small business bookkeeping service.
These documents can help you make the right decisions for your company. How? They give you information about your assets, debts, operational profit or loss, changes over time, investments needed, and the overall financial health of the business. When you can understand them, it’s easier to determine what to do next.
However, if no one has ever shown you how to decipher these statements, you can’t get all the benefits from them. Here’s how to read and understand financial statements from your small business accounting. Of course, we are talking about financial statements reported on the accrual basis of accounting. Read our blog discussing the difference between cash basis and accrual basis of financial reporting, with accrual basis always being the preferred method to really understand the financial health of your business operations.
Is it time for a new small business accounting solution? Reach out to us at Financial Optics for outsourced bookkeeping and outsourced accounting service.
Reading a Cash Flow Statement
A cash flow statement, as the name suggests, provides details of the cash flowing into and out of a business during the accounting period. Remember that cash flow is not identical to profit. The Profit & Loss Statement shows your net profit after deducting all costs and expenses from revenue, and the Cash Flow Statement shows the changes in cash as affected by changes on the Balance Sheet.
Cash flow statements have three main parts. They are all based on the information from your small business bookkeeping records.
Section 1: Cash flow from operating
This section shows revenues and expenses related to the delivery of services or goods. sections start with Net Income and show you the changes in cash due to the changes in balance sheet accounts impacted by operations, such as Accounts Receivable and Accounts Payable.
Section 2: Cash flow from investing
In this section, you will find cash flow related to buying or selling assets. These assets could include expensive operating equipment, real estate, vehicles, intellectual property, or other items that were purchased during the period.
Section 3: Cash flow from financing
This final section establishes cash flows in and out due to increases or decreases in equity or long-term debt.
The last line of each section shows you whether that section had positive or negative cash flow and how much. The bottom line of the entire report shows your overall cash flow for the accounting period.
What It Means to You
In small business accounting, positive cash flow is usually a healthy sign, showing that more money is coming in than going out. If that is the case, you have money to keep operating and even to reinvest and pay off debts. You are set to grow.
Negative cash flow, on the other hand, shows that more money is going out than coming in. This doesn’t necessarily mean your business isn’t profitable. Remember that the Cash Flow statement is reporting on a certain period of time. In some cases, it may just be that during that period you used cash reserves to decrease debt or purchase expensive equipment, or you have recently expanded. If you have a negative bottom line on your cash flow report and don’t know why then you might want to consider seeking financial advice for small business owners.
Reading a Balance Sheet
A balance sheet is a report from your small business bookkeeping that shows what a company is worth. While a cash flow statement shows what happened over an accounting period, such as a quarter, a balance sheet shows one moment in time.
The balance sheet is presented by the following equation: Assets = Liabilities + Owner’s Equity. The balance sheet will balance every time if it is prepared correctly. That is, whatever is on one side of the equation must be the same as what’s on the other side.
This document has three main sections as well.
Assets refer to everything your company owns. Under assets, you’ll find current assets and noncurrent assets.
Current assets are those you expect to convert to cash within a year. Examples could include cash, accounts receivable, and prepaid expenses. Noncurrent assets are all the long-term investments that you plan to keep without converting to cash soon. They could include real estate, intellectual property, goodwill, operating equipment, and patents.
A liability is something your company owes – a debt. There are current and noncurrent liabilities.
Current liabilities could include rent, payroll, utility bills, and accounts payable, for example. You expect to pay off current liabilities within the year. Noncurrent liabilities are the long-term debts and obligations that you won’t pay off in a year. These could include long-term loans and leases.
Owners’ Equity or Shareholders’ Equity
This section lists and totals the amounts that belong to the owners or shareholders after the liabilities are subtracted. Owners’ equity includes money and earnings. Money consists of something contributed to the business, such as shares. Earnings refer to the sum the business generates.
As you look at your Balance Sheet, the start of course is to make sure your Total Assets amount is equal to your Total Liabilities and Equity. If your balance sheet is not in balance, there are underlying issues in your accounting systems.
For small business owners, one of the most important things to determine from your balance sheet is the liquidity health of your business. Do your current assets total up to more than your current liabilities? That is, if you liquidated all your current assets into cash, would you have enough cash to pay off all your current liabilities. That ratio is called your “current ratio”, and for most small businesses this should be at least 1.5. If you are under that ratio, our CFO services can help you develop a plan of attack to improve your liquidity.
What It Means to You
The fact that the balance sheet balances only means your small business accounting has prepared it properly and not made a critical accounting error. What you really need to look at are the numbers in each section. Where are your greatest liabilities? What are your best assets? How can you make the most of your assets and reduce your liabilities? Are you satisfied with the owners’ equity? The answers will give you insight into what to do next.
Reading an Income Statement
You might know the income statement as your profit and loss (P&L) statement. This document provides an accounting of your revenue, expenses, and resulting profit. Your P&L will show you how well your company is performing now, and you can compare it to how well it did in previous accounting periods.
The P&L could include:
- Revenue, including all the money you take in during the accounting period for goods or services provided.
- Overhead Expenses, which is all the money you spent operations overhead, like rent and utilities.
- COGS or COS refers to the cost of making a product (COGS) or delivering a service (COS)
- Gross profit is the amount left from revenue after you pay the COGS or COS
- EBITDA is your earnings before interest, depreciation, taxes, and amortization
- Net income, or the profit you have left after you subtract all your costs and expenses from your revenue. Net income is basically the same as profit.
Reading the Totals
Income statements are easy to read, although deeper analysis can be complex. You can quickly look at the amount for net sales, the cost of sales, and see the resulting gross profit. Reading down the document, you can see expenses, often separated into operating expenses and administrative expenses. You’ll see the income before taxes, the income tax expense, and finally, the net income, which is your net profit.
Of course, you want to have a positive bottom-line net profit. But a key number for many small businesses is making sure your Gross Profit is at the level you expect and need it to be to cover your operating overhead.
Financial Statement Analysis
You can analyze financial statements more deeply. After you read a financial statement to find the amounts of assets, liabilities, revenue, expenses, profit, and other amounts for the period, you can analyze it vertically or horizontally.
Vertical analysis can be helpful when you want to compare one time period to another. This allows you to see if your company’s performance is getting better. Vertical analysis is often used to compare one company to another as well. In vertical analysis, line items are shown as a percentage of a set number, such as a percentage of sales. To do the analysis, you read down the column, comparing the different items and noticing how they relate to each other.
Horizontal analysis, also called trend analysis, also shows percentages. However, in this case, they are percentages of amounts from different reporting periods. This allows you to see the changes that are happening in your company over time. Figures from one date are set as the base, of 100%. then, figures from other dates are shown as percentages of the base. Look at each item and notice how much the amount has changed over the time periods listed.
Financial Advice for Small Business Owners
Financial statements can be confusing if you haven’t spent years reading and analyzing them. That’s why, at Financial Optics, we help you read and understand these documents, and use them as a tool to grow a financially healthier business. Furthermore, we create all these financial statements and more as a part of our small business accounting services. You can count on our exceptional outsourced bookkeepers for consistently excellent service.
We can also assist you with small business accounting software and offer QuickBooks help. With over 30 years of experience as a CPA, Financial Optics founder Tom Sernett provides top-quality financial advice for small business owners nationwide.
Need help deciphering your financial statements? Contact Financial Optics for small business accounting help.