Financial statements are like the financial dashboard of your business. They tell you where your money is going, where it’s coming from, and how much you’ve got to work with. They’re super helpful for making smart business moves. And they’re 100% necessary if you want to get a loan or bring on investors.
If you’re looking for a good intro to financial statements, read on. We’ll go over the basics of each financial statement, and how to read (and use) them—so your business runs like a well-oiled machine.
What are financial statements?
Financial statements are reports that summarize important financial information about your business. There are three main types of financial statements: the balance sheet, income statement, and cash flow statement.
Together, give you—and outside people like investors—a clear financial picture of your business
We’ll look at what each of these three financial statements do, and examine how they work together to give you a full picture of your company’s financial health.
The balance sheet
A balance sheet is a snapshot of your business’s financials as they currently stand. It tells you how much money you have, and where it’s kept, at a particular point in time.
How often your bookkeeper prepares a balance sheet for you will depend on your business.
Banks, which move a lot of money, prepare a balance sheet every day. A small Etsy shop, on the other hand, might get a balance sheet every three months.
Balance sheets are broken up into three general categories: assets, liabilities, and equity.
Here’s an example of what a balance sheet looks like in the Bench app.
Assets are how much money you have to work with, total.
On the Bench balance sheet, assets consist of:
- Money in a checking account and
- Money in transit (being transferred from another account)
Liabilities are money you owe other people. You can’t really consider it cash on hand, available to use, because you’re obliged to give it to someone else. On our balance sheet example, liabilities consist of a bank loan.
Liabilities can also include money you owe in credit payments, taxes, or rent.
Equity is money currently held by the company. This might be retained revenue—money the company has earned to date—as in the example above.
In the Bench balance sheet, you’ll also note a modification to the equity, a shareholder drawing of $7,380.58. This means someone who owns part of the company has withdrawn some money from equity. In corporations and partnerships, this is a way some owners choose to pay themselves.
Equity can also consist of private or public stock, or else an initial investment from your company’s founders.
For instance, suppose you started an online store, and put $1,000 in its bank account as operating capital (to pay web hosting costs and other expenses). Before you even made a sale, that $1,000 would be listed as equity on your balance sheet.
The balance sheet formula
To grasp how the three categories on the balance sheet work together, remember this formula:
Assets = Equity – Liability
To put it simply: Whatever money your business actually has (assets) consists of what it has stored up (equity) minus whatever it owes (liability).
Take on more financial obligations (liabilities), and your assets decrease. Store up more money (equity), and your assets increase.
Using the balance sheet in real life
Here’s an example to explain how it works. Let’s say you run a food cart selling vegan, gluten-free, organic popsicles.
At the end of June, you get a balance sheet from your bookkeeper. It looks like this:
June Balance Sheet
Not bad! It’s summer, your busiest time of year. One month passes.
At the end of July, your balance sheet looks like this:
July Balance Sheet
Nice. You’ve added $1,000 to your retained earnings. But your liabilities haven’t changed. Since you took out a loan to start your business, you’re on a repayment schedule that requires you to may $400 a month.
This is useful information. But it’s not the full picture.
Do your balance sheets tell you…
…how many popsicles you sold? No.
…how much cash you received? No.
…how much it cost you to make the popsicles you sold? No.
…how much you spent on expenses besides debt repayment? No.
This is where the income statement comes in.
The income statement
While the balance sheet is a snapshot of your whole business, the income statement just focuses on your money. How much are you making (revenue)? How much are you spending (expenses)?
Here’s an example of an income statement, from the Bench app.
Revenue: how much you earned from selling popsicles
Cost of Goods Sold (COGS): the total amount it cost you to make the popsicles: popsicle sticks, locally-sourced ingredients, etc. (here’s a fuller explanation of COGS)
Gross Profit: Gross Profit = Revenue - COGS
Operating Expenses: the cost of running your business, not including COGS
Net Profit: Net Profit = Gross Profit - Operating Expenses
Gross Profit: tells you how profitable your products are
When you subtract the COGS from revenue, you see just how profitable your products are. This is very useful. In the above example, the revenue is about 10x the COGS, which is a healthy gross profit margin.
If your COGS and revenue numbers are close together, that means you’re not making very much money per sale.
Further reading: Gross Profit and Gross Profit Margin: A Simple Introduction
Net Profit: tells you how profitable your business is
Just because your products are profitable, doesn’t mean your business is profitable. You could be making a killing on every popsicle, but spending so much on advertising that you walk away with nothing.
Using the income statement in real life
Suppose we have an income statement for July that looks like this:
July Income Statement
|Debt repayment expense||$400|
You sold $1,000 worth of popsicles. If popsicles cost $4 each (they’re vegan, gluten-free, and organic, after all), that means you sold 250 popsicles.
What does this tell us that the balance sheets don’t?
With this info, you know how many more popsicles you have left in inventory—and how many more you should be prepared to make next July.
What else? There are two expenses here besides debt repayment: electricity and maintenance. Looking back over your income statements, you’ll be able to see which months you spend more on electricity (darker, colder months), and roughly how often you need to pay for maintenance on your popsicle cart.
More importantly, you’ll be able to plan ahead for more expensive months (electricity-wise) and know roughly how much money to set aside for maintenance.
You can only get this kind of information from the income statement.
But what’s missing?
Does your income statement tell you…
…how much money you have in the bank? No.
…how much money you owe (eg. in rent)? No.
…how much money is in the business, in the form of Equity? No.
…how much money you had one month ago, six months ago, or a year ago? No.
To get that info, you need snapshots of your business’s finances. You get those from the balance sheet.
Most small businesses track their financials only using balance sheets and income statements. But depending on how you do your accounting, you may need a third type of statement.
The cash flow statement
The cash flow statement tells you how much money you actually have on hand in the form of cash, versus how much is credit.
Cash flow statements are only necessary if you run a business that uses the accrual accounting method. This means your balance sheets and income statements track money entering or leaving the business whether or not the cash is on hand.
For example, if you sold a $5 popsicle to a customer, and took a credit card payment, that $5 would appear as revenue on your income statement, even if you hadn’t received the payment in your bank account.
Here’s an example cash flow statement, using our popsicle stand from before:
The cash flow statement has three parts:
Cash Flow from Operations. This is what you make and spend in the normal course of doing business.
Cash Flow from Investing. This is money you invest—in this case, by purchasing new equipment for your business.
Cash Flow from Financing. This is for the repayment of loans—namely, your monthly debt repayment of $400.
Using the cash flow statement in real life
The cash flow statement tells you how much money—not credit, unpaid invoices, or scribbled IOUs—you have on hand. That means you know whether you’ve got enough cash to cover rent or pay the heating bill.
The other financial statements show money going into different accounts. If you have $1,000 in accounts receivable, they tell you that you’ve been paid $1,000.
But if your clients haven’t paid you that money yet, you don’t have the cash on hand. So the cash flow statement “corrects” line items—for instance, deducting that $1,000 from your total income, since you can’t spend it yet.
What does this cash flow statement tell you?
Mainly, this statement tells you that, despite pretty nice revenue and low expenses, you don’t have a lot of cash flow—just $200 for the month.
To free up that money, you need to speed up your Accounts Receivable. Right now, all your income is tied up there—let’s say your popsicle stand uses only accepts credit card and debit, and your service provider pays you out at the beginning of the month. You need to find a way to get cash in hand faster. That could mean biting the bullet and accepting cash, or it could mean switching service providers.
In either case, your cash flow statement has shown you a different side of your business—the cash flow side, which is invisible on your balance sheets and income statements.
Further reading: How to Manage Cash Flow (And Make Better Financial Decisions)
Using financial statements to grow your business
Once you get used to reading financial statements, you might get addicted. By analyzing your expenses and revenue, and looking at past trends, you’ll start seeing many ways you can experiment with optimizing your business.
Here are a few practical ways financial statements can help your business grow.
Investing in assets
Say your popsicle cart blows a tire every other month, and you have to pay $50 in maintenance expenses each time. That’s $300 a year (as you’ve learned from your income statements).
But suppose the cost of buying a new, top-of-the-line cart, one that has kevlar tank treads instead of rubber tires, is $600. You can calculate that, over the course of two years, it’ll pay for itself.
Securing a loan
One person can only serve so many popsicles. Suppose you can’t keep up with demand during the busy summer months. The line at your cart grows so long some days, people get frustrated and leave before they even buy one of your popsicles.
At this point, it may make sense to hire a second (seasonal) employee and get a bigger cart. But you need a loan in order to do that.
Before lending you more money, the bank will want to know the history of your business. They want to know you’ll still be in business one year from now, and able to pay off your loan.
That’s when financial statements are invaluable. With properly prepared balance sheets and income statements, you’re equipped to prove your business is sustainable—and get ahold of the resources you need to expand it.
Finally, without properly prepared financial statements, filing your taxes can be a nightmare. Not only do they tell you how much income to report, but financial statements give you an overview of the expenses you’ve incurred—some of which can be written off as small business tax deductions.
By carefully collecting data and crunching the numbers, you can prepare your own financial statements.
But, chances are, you didn’t start your own business so you could be hunched over a calculator every night. That’s where a bookkeeper comes in handy.
An experienced bookkeeper can prepare your financial statements for you, so you can make smart financial decisions without all the tedious admin. Plus, come tax time you’ll know your financials are 100% comprehensive and correct, ready to be handed off to your accountant.
Grab a popsicle and take some time to read our article on choosing the best bookkeeping solution for your business.