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 accounting information about your business. There are three main types of financial statements: the balance sheet, income statement, and cash flow statement.
Together, they give you—and outside people like investors—a clear picture of your company’s financial position.
We’ll look at what each of these three basic 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 finances as it currently stands. It tells you about the assets you own, and liabilities (i.e., debts) you owe, at a particular point in time.
How often your bookkeeper prepares a balance sheet for you will depend on your business. Some businesses get daily or monthly financial statements, some prepare financial statements quarterly, and some only get a balance sheet once a year.
For example, banks move a lot of money, so they prepare a balance sheet every day. On the other hand, a small Etsy shop might only 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 if you’re a Bench customer.
Assets are anything valuable that your company owns.
On the Bench balance sheet shown above, assets consist of:
Money in a checking account and
Money in transit (being transferred from another account)
But total assets can also include things like equipment, furniture, land, buildings, notes receivable, and even intangible property such as patents and goodwill.
Liabilities are debts you owe to other people. On our balance sheet example above, the only liability is a bank loan. But total liabilities can also include credit card debt, mortgages, and accrued expenses such as utilities, taxes, or wages owed to employees.
Equity is the remaining value of the company after subtracting liabilities from assets. 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 shareholder’s equity. This is a way some business 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 owner’s equity on your balance sheet.
It’s important to note that equity is only the “book value” of your company. It’s not your business’ market value if you wanted to sell the business. When selling a business, buyers usually pay more than the book value of the business based on things like the company’s annual earnings, the market value of tangible and intangible property it owns, and more.
The balance sheet formula
To grasp how the three categories on the balance sheet work together, remember this formula:
Equity = Assets – Liabilities
To put it simply: Whatever value (equity) your business actually has consists of what it owns (assets) minus what it owes (liabilities).
Further reading: What Are Assets, Liabilities, and Equity?
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
|Credit card debt||$400|
Not bad! It’s summer, your busiest time of year. One month passes.
At the end of July, your balance sheet shows this:
July Balance Sheet
|Credit card debt||$400|
Nice. You’ve added $1,000 to your retained earnings by saving more cash, even though your liabilities haven’t changed.
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? No.
This is where the income statement comes in.
The income statement
While the balance sheet is a snapshot of your business’s financials at a point in time, the income statement (sometimes referred to as a profit and loss statement) shows you how profitable your business was over an accounting period, such as a month, quarter, or year. It shows you how much you made (revenue) and how much you spent (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: 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
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 the income statement tell us that the balance sheet doesn’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 interest expense: electricity and maintenance. Looking back over your income statements, you’ll be able to see which months you spend more on electricity, 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 to your credit card company? No.
…how much equity you have in the business? No.
…how much money you had one month ago vs. six months 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 financial reporting, you may need a third type of statement.
The cash flow statement
The cash flow statement tells you how much cash entered and left your business over a particular time period.
Cash flow statements (also known as the statement of cash flows) are typically only prepared for companies that use the accrual accounting method. This is because under the accrual method, a company’s income statement might include revenue that the company has earned but not yet received, and expenses the company has incurred but not yet paid.
For example, under the accrual method, if you sold a $5 popsicle to a customer, and accepted an I.O.U. as 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 Flows from Operations. This is what you make and spend in the normal course of doing business.
Cash Flow from Investing Activities. This is money you invest—in this case, by purchasing new equipment for your business.
Cash Flow from Financing Activities. This includes money the owner invested in the business, as well as taking out and repaying loans. In this case, the business got additional financing in the form of a $1,200 bank loan.
Using the cash flow statement in real life
The cash flow statement tells you how much cash you collected and paid out over the year. This can help you predict future cash surpluses and shortages, and help you plan to have enough cash on hand to cover rent or pay the heating bill.
A balance sheet might show you have $1,000 in accounts receivable, and your income statement shows you earned $1,000 of revenue. 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 cash on hand, since it’s not yet available to cover your costs.
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 inflows from your normal operations—just $100 for the month. Most of your cash on hand came from the proceeds of a bank loan.
To increase your company’s cash flow from operating activities, you need to speed up your accounts receivable collection. That could mean telling customers you’ll only accept cash rather than I.O.U.s, or requiring your customers to pay outstanding invoices within 15 days rather than 30 days.
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.
Using financial statements to grow your business
Once you get used to reading financial statements, they can actually be fun. By analyzing your net income and cash flows, and looking at past trends, you’ll start seeing many ways you can experiment with optimizing your financial performance.
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 about your company’s financial position. They want to know how much you make, how much you spend, and how responsible your company’s management is with your business finances. This information is a good indicator of whether you’ll be in business long enough 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 financial statements tell you how much income to report, but they also give you an overview of the expenses you’ve incurred—some of which can be written off as small business tax deductions.
How Bench can help
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 paperwork. Plus, when it’s time to file your income taxes, you’ll know your financials are 100% comprehensive and correct, ready to be handed off to your accountant.
Don’t have a bookkeeper? Check out Bench. We’ll do your bookkeeping for you, prepare financial statements every month, and give you access to the Bench app where you can keep tabs on your finances. Learn more.