This post was originally published March 10, 2015, and updated February 26, 2020.
If you had to summarize the financial standing of your business, how would you do it? For many business owners, that’s a difficult question to answer for one reason: they don’t understand accounting terms or how to read financial statements.
At CMP, we work with business owners every day. Even those who think they have a handle on their finances sometimes misinterpret the information on their key reports, which include the balance sheet, the income statement, and the cash flow report.
To help you, we’ve put together this quick guide to help you learn how to read financial statements. Here’s what you need to know:
What Are Financial Statements?
Let’s start with the basics. Financial statements are a collection of key financial reports that provide an overview of your company’s financial status. The three most important reports to read are the ones we mentioned in the introduction: the balance sheet, the income statement, and the cash flow report.
When you understand your business’s financial statements, you’ll have the information you need to make smart decisions about growing your company. You’ll need financial statements if you want to approach investors or lenders. It might be helpful to think of them as your company’s money report card, as they include key indicators that point to areas of success and areas where you need to improve.
How to Understand the Balance Sheet
The balance sheet is like a snapshot of your company’s finances as of the date the report is run. Unlike the other reports we’ll discuss, the balance sheet carries forward year to year. You can look at a balance sheet at any time to get an overview of your finances.
The basic formula used to create a balance sheet is Assets = Liabilities + Owner’s Equity.
It provides the following information:
- Business Assets – Your assets include what you own plus what you control, including items such as cash, fixed assets, investments, inventory, and accounts receivable.
- Liabilities – Your liabilities include everything you owe, including accounts payable, credit card balances, loans, and taxes.
- Owner’s Equity – The owner’s equity is whatever is left over after you subtract your liabilities from your business assets. This may be a negative or a positive number. If it’s negative, your business is “in the red,” meaning that you own less than you owe.
You can look at your balance sheet daily, monthly, or quarterly depending on your needs.
Using the Balance Sheet in Your Business
Here are some tips for using your balance sheet to manage your business:
- Analyze with ratios. Choose a few key ratios to run on a recurring basis. Some helpful ratios include:
- Current ratio – Current assets divided by current liabilities
- Working capital – Current assets minus current liabilities
- Debt to Equity ratio – Total liabilities divided by owner’s equity
- Read your balance sheet regularly. The more familiar you are with your reports, the better you will become at spotting and addressing trends.
- Understand that your current assets are short-term resources and most often include cash and items that you can convert to cash within the fiscal year--usually cash, accounts receivable, and prepaid expenses. Likewise, your current liabilities are short-term obligations, including debt that must be paid within the current year, such as accounts payable, payroll taxes, and short-term notes.
We suggest looking at your balance sheet daily until you’re comfortable reading it.
Understanding the Income Statement
The income statement is a report that tells you how profitable your business is over time. You can run an income statement at any time to understand how much your business has earned and how much you’ve spent.
What the Income Statement Can Tell You About Your Business
When you look at your income statement, there are a few ratios you can use to learn more about your business.
- Gross margin. Calculate by dividing your gross profit by the net earned or by subtracting the cost of goods sold (COGS) from your net sales.
- Profit margin. One of the most important ratios to determine your profitability. Calculate it by dividing your net income after tax by your net sales.
- Operating margin. Calculate by dividing your operating income by your net sales.
The income statement should be used to determine the overall profitability of your business and is an essential tool when talking to shareholders and investors.
What is the Cash Flow Report?
The cash flow report is essential because it tells whether your business has enough cash to stay afloat. Poor cash flow is the number one reason that small businesses fail. The cash flow report is typically used by companies that use the accrual accounting method because the income statement might include money that has been accrued but not yet received.
How to Use the Cash Flow Report in Your Business
Here are some tips for using the cash flow report in your business.
- Run ratios to get a handle on your cash flow. The most important ratios are:
- Operating cash flow/net sales – this ratio tells you how many dollars of cash you get for every dollar of sales. A higher percentage is better than a low one.
- Free cash flow, which you can calculate by dividing the cash flow provided by subtracting your capital expenditures from the cash flow provided by operating activities. This ratio will tell you how much cash is left over after you pay for your capital expenditures.
- Spot issues with accounts receivable. For most companies, low cash flow indicates that customers are slow to pay.
The best way to address cash flow issues is to find ways to turn over your accounts receivable more quickly. For example, you could require customers to pay in cash or reduce your terms to make invoices due in 15 days instead of 30 days.
Using Financial Statements to Increase Your Revenue
If you use them properly, your company’s financial statements can help you pinpoint financial issues as soon as they arise and to increase your revenue. As we mentioned above, a cash flow problem could be remedied by collecting invoices more quickly.
Another example would be profitability. Your income statement might reveal that you are paying too much for raw materials. A solution might be to seek out a supplier with lower prices or to negotiate a bulk discount with your existing suppliers.
Every business should have accurate financial statements. As a business owner, it’s your responsibility to know how to read financial statements and use the information from them to increase your profits and improve the financial health of your organization.
Need assistance in creating accurate financial statements for your business? CMP can help you with
- Financial Statement Preparation
- Complied Financial Statements
- Reviewed Financial Statements
- Audited Financial Statements