How to Read Financial Statements

By Cameron McCool on February 27, 2018

There are two common misconceptions about financial statements.

  1. Understanding financial statements is hard
  2. You can run your business without financial statements, and get away with it

Let’s clear these up.

First, financial statements aren’t just for full-time number-crunchers with fancy letters after their name. After reading this article, you’ll be able to start reading financial statements right away and get at least some benefit out of them.

Second, financial statements are critical to your small business, if you like money and getting more of it. Without financial statements, you won’t be able to do things like plan your expenses for next year, invest in important assets, secure a loan, or sell your business.

Accounting 101: Set Your Finances up the Right Way

Learn the fundamentals of small business accounting, and set your finances up for success with this free guide.

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, they tell you where your business’s money is, and how it got there.

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.

Balance Sheet Example

Assets

Assets are how much money you have to work with, total.

On the Bench balance sheet, assets consist of:

  1. Money in a checking account and
  2. Money in transit (being transferred from another account)

Liabilities

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

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

Assets

Bank account: $1,200

Liabilities

Debt repayment: $400

Equity

Retained earnings: $1,600

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

Assets

Bank account: $2,200

Liabilities

Debt repayment: $400

Equity

Retained earnings: $2,600

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.

Income Statement-updated-thinner

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.

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.

Accounting 101: Set Your Finances up the Right Way

Learn the fundamentals of small business accounting, and set your finances up for success with this free guide.

Using the income statement in real life

Let’s return to the example of the popsicle cart from the balance sheet section.

You’ll remember the balance sheets looked like this:

June Balance Sheet

Assets

Bank account: $1,200

Liabilities

Debt repayment: $400

Equity

Retained earnings: $1,600

July Balance Sheet

Assets

Bank account: $2,200

Liabilities

Debt repayment: $400

Equity

Retained earnings: $2,600

Now, suppose we have an income statement for July that looks like this:

July Income Statement

Revenue: $1,000

Expenses: $500

Debt repayment expense: $400

Electricity expense: $50

Maintenance expense: $50

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 friend for an IOU, that $5 would appear as revenue on your income statement, even if your friend still owed you cash.

Many small businesses use cash basis accounting because it’s the simplest approach. This means they only record transactions when they receive money.

So, in the example of the popsicle bought with an IOU, using the cash basis method, $5 would not be added to revenue until your friend paid up.

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.

Taxes

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.

Accounting 101: Set Your Finances up the Right Way

Learn the fundamentals of small business accounting, and set your finances up for success with this free guide.


This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.

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