Reading financial statements typically isn’t on the top of a small business owner’s to-do list. This is largely because many small business owners are confused by these statements. Instead of clarifying their business’s financial position, financial statements often serve to confuse business owners. As a result, you might find yourself dependent on your business accountant—who most business owners speak with only once or twice a year—to explain your business’s finances. Or, you might rely exclusively on your bank account balance to make business decisions.
Business owners who do read their financial statements typically only focus on one of the three key financial statements. While this is better than not reading the statements at all, focusing exclusively on one statement only provides part of the story. And this can lead to further confusion instead of providing clarity.
Your financial statements tell the story of your business. If you ignore them altogether, you are missing out on a narrative that will give you a complete picture of your business’s financial health. But reading financial statements can be a bit like reading literature: without some guidance, you might miss out on key elements that transform the story from confusing, boring, or just “okay,” to a story you willingly revisit again and again.
Your business’s financial story is comprised of three key financial statements. Let’s take a look at each of these statements in turn, as well as how they work together to form a comprehensive story of your business’s finances.
Financial Statement 1: The Income Statement
The income statement, also called the profit and loss statement (or P&L), is probably already familiar to you. This is the financial statement most business owners focus on, because it is the easiest to understand. It also concludes with the business’s net income (or profit)—something all business owners want to know.
The income statement can be summarized by the following equation:
Income – Expenses = Net Income (or Profit)
Your income statement tells the story of your business’s income and expenses for a period of time. Typically, income statements are produced for a month, a quarter, or a year. There is no rule saying you can’t look at income statements for a particular day, week, or even multiple years, although looking at the profit and loss for these time periods is usually not particularly helpful.
Parts of the Income Statement
Even though the income statement equation is simple, there are multiple parts to the income statement:
- Operating revenue: This is the revenue from your business’s operations, or primary activities (sales). The operating revenue section of your income statement also includes customer returns or refunds.
- Cost of goods sold: Also called cost of sales, COGS, or COS, these are the expenses that go directly into the making of your product or the delivery of your service. These expenses can include labor, materials, and shipping costs, just to name a few. Cost of goods sold appear directly after your operating income, and, when subtracted from your operating income, show you your gross profit.
- Operating expenses: As the name implies, operating expenses include all the expenses that comprise your business’s operating—or overhead—expenses. These expenses can include rent, payroll, insurance, and any number of other expenses.
- Other income and expenses: Some income and expenses aren’t directly related to your business’s operations. Rebates and interest expenses are common examples of other income and expenses. These deposits and expenses are separated from operating income and expenses for the sake of clarity. By listing them in a separate section of the income statement, you can easily see the narrative of your operating activities.
- Net income: This is the “bottom line” on your income statement. Net income—also called net profit—is what is left after all your business’s expenses are subtracted from all your business’s income.
Let’s be clear: The income statement is a very important chapter in your business’s financial story. But it’s only one chapter, and focusing exclusively on this chapter will give you only part of the narrative. You owe it to yourself—and your business—to continue to the next chapter.
Financial Statement 2: The Balance Sheet
Every transaction in your business impacts the balance sheet. Unfortunately, many business owners ignore the balance sheet, because they don’t understand its importance.
Simply stated, the balance sheet shows what your business owns and what it owes. Whereas the income statement shows income and expense activity for a period of time, the balance sheet shows a summary of your business’s complete financial position as of a particular date.
The balance sheet can be summarized by this equation:
Assets = Liabilities + Equity
Parts of the balance sheet
As the name implies, the balance sheet must be in balance, meaning the sum of liabilities and equity must equal the assets. But what are assets, liabilities, and equity?
- Assets: Assets are part of what your company owns. Assets include concrete things like money in the bank, furniture and equipment, buildings, and vehicles. But assets also include intangible things, like accounts receivable, patents, and goodwill. Assets can be further sub-categorized as fixed—or long-term—assets, and current—or short-term—assets. Long-term assets are expected to last more than a year, and short-term assets are expected to last for a year or less.
- Liabilities: Liabilities are what your company owes. You can think of liabilities as your business debts—expenses your company hasn’t paid yet. Liabilities include accounts payable, credit card balances, and outstanding loan balances. Like assets, liabilities can be subcategorized as long term or short term. Most loans are long-term liabilities, whereas accounts payable and credit card balances are short-term, or current, liabilities.
- Equity: Equity is what is left after your business’s liabilities are subtracted from your business’s assets. Equity can be further broken down into a number of different subcategories:
- Retained earnings: This is the money that stays in the business after owner draws, shareholder distributions, or other dividends are paid. Retained earnings are cumulative, meaning they add up year over year.
- Contributions: This is the amount of money paid into the business by the owner or shareholders. Contributions consist of paid in capital and capital stock.
- Treasury stock: Treasury stock is the portion of a company’s stock which the company retains. Treasury stock is uncommon in small business finance.
Ideally, equity will be a positive number on the balance sheet. Unfortunately, this isn’t always the case. Excessive liabilities or excessive draws and distributions can result in negative equity. When this happens, liabilities exceed assets, which could indicate trouble for the business. At the very least, it puts the business owner in an unfavorable position if they wish to sell the business.
As mentioned earlier, every transaction in your business impacts the balance sheet in some way. And the balance sheet summarizes your business’s overall financial position, making it a key financial statement and a crucial chapter in your business’s financial story.
Financial Statement 3: The Statement of Cash Flows
Whereas the income statement and balance sheet can be produced on either an accrual or cash basis, the statement of cash flows is strictly an accrual basis statement. Because of this—and because it is often difficult for even seasoned financial professionals to understand—the statement of cash flows is often ignored.
This is a mistake.
The statement of cash flows is arguably the most important of the three financial statements. It reconciles the balance sheet to the income statement and answers the question every business owner wants to know: “Where did the money go?”
If you’ve ever looked at the net income on your income statement and wondered why it doesn’t match the balance in your bank account or even on your business’s balance sheet, the answer lies in the statement of cash flows.
A Simplified Deconstruction of the Statement of Cash Flows
The statement of cash flows can be presented in any number of ways, and how to read this statement could be the subject of its own article. But let’s take a moment to run through a basic deconstruction of this financial statement:
- Net income: This number is pulled directly from the accrual basis income statement.
- Balance sheet activity: Balance sheet activity—like outstanding accounts payable and receivable, loan payments, draws and distributions, and investments—impact a business’s bank account balance. However, this activity doesn’t appear on the income statement, and it can be difficult to detect on the balance sheet itself.
On the statement of cash flows, the net income number on the income statement is adjusted by this balance sheet activity.
- Increase or decrease in cash: The statement of cash flows—like the income statement—is produced for a period of time. The increase or decrease in cash section of the statement of cash flows shows whether your business’s cash balance has increased or decreased for the period under review.
An increase in cash could mean you brought in more money than you spent, or it could mean you made an investment into the business which impacted your cash position. Cash can also increase if you draw off a line of credit.
A decrease in cash means your business spent more money than it made in the period. This can happen even if your income statement shows a profit. Again, it is possible for cash to decrease even in a profitable month, because certain cash expenditures don’t impact the income statement.
- Cash at end of period: This is the “eureka!” portion of the statement of cash flows. Why? Because, at long last, we have a financial statement with an ending number that matches your bank account balance, or the sum of your bank account balances, as of the ending date of the statement. We finally have the answer to the question, “Where did all the money go?”
Bonus: The Statement of Retained Earnings
You might have heard of something called a statement of retained earnings. This is the least common financial statement and usually not included in a small business’s financial statements, so we won’t spend much time on it here. In short, the statement of retained earnings is a detailed reporting of changes to the equity section of the balance sheet.
Financial Statements: The Complete Financial Story
We intentionally discussed the income statement first in this article, because it is the most familiar financial statement. However, in formal presentation, the balance sheet is the first financial statement presented. This is because the balance sheet is a complete summary of the business’s financial health over the business’s entire lifespan.
But the order you read your financial statements doesn’t really matter. What does matter is that you understand the purpose of each statement and how all three statements work together.
Your business’s financial story is told not only in the individual financial statements, but also in the relation of each statement to the others. Reading financial statements can be difficult at first, but it doesn’t have to be an intimidating task.
Just like your high school English teacher taught you to decode Shakespeare and Hemingway, your accountant or bookkeeper can help you decode your financial statements. And, as was the case for your English teacher, part of the joy of our profession is helping you understand your business’s story. With time, your financial statements will become a story you look forward to reading on a regular basis, which, in turn, will make you a more effective and successful business owner.