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Understanding the Basics of Financial Statements

By November 21, 2022No Comments

Understanding the basics of financial statements is an important skill for any business owner. By having a basic understanding of the three main financial statements – balance sheet, income statement, and cash flow statement – you are able to see a clear picture of your company’s financial health and make informed financial decisions. 

However, not all business owners are financial experts, and we understand that it can be a challenge to get a grasp on these statements. So we’re breaking down the basics of balance sheets, income statements, and cash flow statements that you need to know. 

Understanding Balance Sheets

A balance sheet is one of the most valuable financial statements when it comes to understanding the financial position of a business. The balance sheet is based on past data and provides a snapshot of the business’s financial position at that time. 

Components of a Balance Sheet

Balance sheets are broken down into three components: assets, liabilities, and owner’s equity. Assets are what the company owns. Liabilities are what the company owes. And owner’s equity is the difference between the two. The most important thing to remember when it comes to a balance sheet, is that it must balance. 

In order for a balance sheet to be balanced, these three equations must always be true: 

Assets = Liabilities + Owners Equity

Owner’s Equity = Assets – Liabilities

Liabilities = Assets – Owner’s Equity

Here is a breakdown of each of those three components.

Assets

Put simply, assets are anything that the business owns. These assets are broken down into two categories: current and non-current assets. 

Current assets include anything that’s expected to convert into cash within a year such as inventory, accounts receivable, cash and cash equivalents, and prepaid expenses. While non-current assets include long-term investments that aren’t expected to convert to cash anytime soon such as land, patents, and equipment. 

Liabilities

Liabilities are just the opposite of assets and are anything that the company owes. Liabilities are also broken down into current and non-current. 

Current liabilities are typically due within the year such as payroll expenses, rent, utilities, and accounts payable. Non current liabilities are long-term obligations such as leases, loans, and deferred tax liabilities. 

Owner’s Equity

Owner’s equity (also referred to as shareholders’ equity or net worth) refers to anything that belongs to the owners of a business after liabilities are accounted for. This can include share capital, reserves, and retained earnings.

Purpose of a Balance Sheet

As previously mentioned, a balance sheet is one of the most crucial financial statements for understanding the current position of a business. Balance sheets can be used for different purposes, depending on who is reviewing them. 

Balance sheets can be used internally to give insight as to whether a company is successful. Based on their review, company officials can change their strategies based on what’s working and what’s not. 

Balance sheets can be used externally when someone is interested in investing in a company. The balance sheet provides the potential investor with insight about the company’s resources and how they were financed, allowing them to determine if this is a wise investment. 

While balance sheets are extremely beneficial and provide valuable information, don’t forget that they are based on past data. It’s important to remember that past performance does not always indicate future results. 

Understanding Income Statements

While each financial statement is important to understanding a company’s financial health, the income statement is probably the most common and most critical.

An income statement, also known as a profit & loss (P&L) statement, shows a company’s financial performance over a period of time. They are typically produced monthly and annually and summarize all income and expenses over that given period of time.

Components of an Income Statement

An income statement provides a detailed breakdown of income and expenses throughout the reporting period and typically includes the following information:

  • Revenue
  • Expenses
  • Cost of goods sold
  • Gross profit
  • Operating Income
  • Income before taxes
  • Net Income
  • Earnings per share
  • Depreciation
  • EBITDA (earnings before interest, depreciation, taxes, and amortization)

Each of these components can be further broken down into individual line items if needed. The information reported is used to show how profitable a company is during the reporting period. 

Purpose of an Income Statement

Income statements can be reviewed both internally and externally. Accountants, investors, and company officials regularly review income statements to keep a finger on the pulse of the company’s financial health. 

Regularly reviewing income statements can help determine whether a business is profitable and determine financial trends, such as when costs are highest or lowest. 

Understanding Cash Flow Statements

A cash flow statement provides a detailed picture of where cash is being generated and used within a business during a specified period of time. This helps provide business owners with a picture of how the business is able to operate in both the short- and long-term based on how much cash is flowing in and out. 

Components of Cash Flow Statement

Cash flow statements are broken down into three components: operating activities, investing activities, and financing activities. 

Operating activities include the day-to-day business operations. It records both revenues and expenses that have been collected and paid during the specified time period. Investing activities include the cash flow from purchasing and selling assets, such as property or equipment. Financing activities include the cash flow from both debt and equity financing.

Purpose of a Cash Flow Statement

A cash flow statement helps business owners see the types of activities that generate cash for the company, allowing them to use that information to make financial decisions for the business. 

It is important to remember that cash flow does not equal profit. Cash flow refers to the cash constantly flowing in and out of a company, while profit is what remains after all expenses have been deducted from the company’s revenue. 

Partners in Your Success

Understanding the basics of each financial statement is important knowledge for business owners. Each of these financial statements work together to paint a clear picture of a company’s financial health. By reviewing these financial documents, you are able to gain key financial insight in order to make sound financial decisions for your business. 

If you need help creating, analyzing and understanding your company’s financial statements, reach out to us. Our team is here to create and help you understand your financial statements so that you can take the right steps toward improving your company’s financial health. Let us be partners in your success. Schedule your free consultation today.