Learning how to read financial statements is kind of a big deal. Practically every decision about a business should be made with financial statements. Tax agencies require them. And lenders or investors will only take businesses seriously if these documents are in order.
While financial statements might seem intimidating at first, they’re simply a formal record of the financial activities of a business, person, or other entity. If you’re new to the world of entrepreneurship and wondering how to read financial statements, you’re in the right place.
In this guide, we’ll explain each type of financial statement you’re likely to encounter, why your company needs these reports, and how you can use the information they provide to grow your business.
How to Read Your Financial Statements
Three main documents make up a standard set of financial statements. You’ll need to learn how to read each type of financial statement, and use the information they hold to inform strategic business decisions.
Sometimes referred to as “a statement of financial holdings,” a balance sheet reports the dollar amounts of a business’s assets, liabilities, and owners’ equity.
Its purpose is to give you, the business owner, and other important stakeholders a snapshot of your business’s financial position, as well as displaying what your business owns and owes.
A balance sheet has three main elements:
- Ownership equity
The components of the balance sheet work together according to the following formula:
Assets = Liabilities + Owners’ Equity
Assets refer to economic resources like cash, accounts receivable, and inventory. Liabilities, on the other hand, include items such as accounts payable, deferred tax liabilities, deferred assets, and revenue for services paid but not yet provided. Finally, owners’ equity refers to capital from owners or shareholders. Using the simple formula shown above, the balance sheet shows how much a company owns and owes.
A statement of comprehensive income, known as an income statement (sometimes called a Profit and Loss Statement), shows a company’s revenue and expenses during a particular period and accurately conveys the “bottom line” for a company. Income statements show “how much revenue a company earned over a specific time period” such as a year, quarter, or month. Some income statements may also show the earning per share (EPS), which is how much money each shareholder receives.
Cash Flow Statements
If a company is using accrual accounting, the income statement and balance sheet may not accurately represent how much cash is in the coffers at a given time. In this case, a cash flow statement can be used to show how much cash a business has on hand to pay expenses and acquire assets.
While cash flow statements aren’t needed by small businesses that often, individuals such as accounting personnel, potential lenders, creditors, investors, employees, and contractors as well as shareholders do use them when evaluating the financial health of the company.
How to Grow Your Business Using Financial Statements
In a sense, financial statements are the dashboard of a company’s financial health. As such, they’re useful to various stakeholders who need to know how well (or how poorly) a company is performing.
At a high level, financial statements clearly document where money is coming from, and where it goes. Each type of major financial statement provides more detailed information about a company’s productivity.
For example, by looking at the company’s balance sheet, an owner can clearly see a snapshot of what his or her liabilities are, the amounts contributed by investors, and the value of all assets. By comparison, income statements clearly show where money is being earned (revenues), where it is being spent (expenses) and what is left over (net profit).
Lastly, with a cash flow sheet, owners can look across a period of time to review where money has entered and exited the business and for what purpose. These three documents combined, provide a comprehensive view of the financial health of a company which is important for owners (current and future), employees, and shareholders.
The benefits of financial data extend beyond just knowing ‘the numbers’. With properly kept financial statements owners and managers can use financial statements when making strategic business decisions. For example, if a company is considering expansion, the information from the financial statements will be able to inform the company as to how much growth is realistic and sustainable. As part of that expansion, they may need to seek financing, at which point potential lenders will need to have an accurate picture of the company in order to determine how much money to lend and at what rate.
Financial statements are vital to monitoring a company’s financial health and for making important business decisions. Like any data product though, financial statements are only as good as the information going into them.
In addition, accurate financial statements are extremely valuable if you intend to approach investors and seek capital for your business. Potential investors and lenders will ask for your financial statements in order to determine if your business is a good investment.
Who Prepares Financial Statements?
Preparing financial statements generally requires support from your bookkeeper and your accountant. First, your bookkeeper or bookkeeping service will gather and process your business’s raw financial data. Your accountant will then use the information found in your business’s books to prepare and analyze your financial statements.
Although you can outsource all of this work, it’s important that you, the business owner, can interpret and the information in your financial statements. Make sure you work regularly with your accountant to analyze your financial statements and use the data to help your business grow.
Whether you decide to prepare financial statements yourself, or outsource the task to a bookkeeping service like Bench, having professional, accurate reports doesn’t just keep things organized internally. It demonstrates to stakeholders and important outsiders that your company’s financial house is in order. Learn how to read financial statements, and leverage the information they hold to your advantage.