Understanding and Utilizing Financial Statements for Small Businesses
October 5, 2021 | Last Updated on: July 24, 2022
October 5, 2021 | Last Updated on: July 24, 2022
As a small business owner, understanding your business cash flow is essential. If you know where money is coming in and where money is going out, you can make crucial decisions to help your business grow.
Financial statements are the tools that will help you do just that. They give you a snapshot of your business’s financial health and will guide you to identifying trends within your operating activities. They will also help you pinpoint any cash flow problems that you may not already be aware of.
This article will help you navigate the world of financial statements so that you can understand how they impact your business growth and how they can assist you with making smarter business decisions.
We talk about financial “health” a lot in this article, so it’s fitting that we consider you the doctor and your business the patient. And just as a doctor would do an x-ray if he needed to quickly check on your bone health, financial statements are important because they provide a clear view of the inside of your business operations. They give an “x-ray” of your organization’s financial health and total assets.
Financial statements aren’t just for your personal use, however. Suppose your next move is to get investors on board for a startup, or to apply for credit or a bank loan. In that case, your organization’s financial statements, along with your business plan, will be the deciding factor in whether outside financial sources are interested in working with you. They will be looking at your market value, your financial performance, and in particular, what your net profit is.
Corporations, both large and small, also use financial statements to provide accurate reporting to government agencies and auditors.
You need to be aware of three primary financial statements: the balance sheet, income statement, and cash flow statement. Each one of these statements serves a different purpose, but together they give a clear view into your company’s operating activities.
While those are the most common financial statements, you can utilize others for small business growth too.
The balance sheet is also known as the statement of financial position. It reports on the business’s assets, liabilities, and owner’s equity. It essentially says what a company owes, owns, and how much has been invested by shareholders.
Balance sheets are necessary because they give a snapshot of a company’s finances during a specific accounting period; such as monthly, quarterly, or yearly. They don’t necessarily help in discovering trends, but you can see how your organization is fairing by comparing various balance sheets from equal points in time: such as quarter to quarter or year to year.
While the balance sheet can give you inside information on the health of your organization, these reports are used heavily by investors who also want to get a sense of your business’s well-being. Most investors will use the information from these statements by calculating the debt-to-equity ratio, acid-test ratio, and many other ratios.
The debt-to-equity ratio can showcase a company’s leverage. In short, it shows how much of the organization runs on incoming cash flow vs. debt. Investors use this ratio to determine if shareholders’ equity would be enough to cover any outstanding debt if the business took a turn for the worse. Investors will calculate this ratio by dividing the business’s total liability by its shareholders’ equity.
Investors use the acid-test ratio to determine a business’s liquid assets. It generally ignores inventory and identifies what can quickly be liquidated. It’s calculated by adding the business’s cash, marketable securities, and accounts receivable, then dividing that total by its current liabilities.
Statement of Shareholders’ Equity
The statement of shareholders’ equity is a part of the balance sheet, but it’s important enough to get its own little section of this article. This statement will be presented to shareholders so that they can see how their investment is paying off. It shows the value of the organization from start to finish.
If the shareholders’ equity is increasing, that means that whatever avenues the business is taking to increase profits is working. If it’s decreasing, that means that you, as the business owner, might want to reconsider those activities.
Organizations of all sizes use this helpful addition to the balance sheet. If you’re a small business owner that’s running your business as a sole-proprietorship, however, you would most likely refer to “shareholders’ equity” as “owner’s equity” instead.
Income statements are also known as profit and loss statements and report on a company’s income, expenses, and profit/loss over a specific period. They focus on four main elements: revenue, expenses, gains, and losses.
Income statements don’t consider whether there are cash or non-cash payments or disbursements because the technicalities between payments don’t matter. Income is income on this statement, regardless of what model of payment it comes in on. These statements do, however, differentiate between operating and non-operating revenue.
Operating revenue is revenue that comes from primary sources within the organization. If your business manufactures products, the operating income would be from any sales of that product.
Non-operating revenue comes from a non-direct source. This could be recurring income gained from interest earned on investments, business capital, royalty payments, or from renting out business property.
Gains are the type of income your organization receives that isn’t recurring but isn’t tied to operating income. It can come from a one-time sale of business assets, such as company vehicles or property.
Often split into two categories (primary and secondary), reported expenses on the income statement are any cost associated with business operations.
Primary expenses include the cost of goods sold (COGS), depreciation of equipment, administrative fees, employees, research and development, and general operational costs.
Anything not tied to business operations is considered a secondary expense, such as interest paid on a loan.
As you can see, the income statement is a clear representation of how healthy your business finances are. It’s also called the profit and loss statement for a reason. By utilizing an income statement, you will determine how much profit or loss you’re taking on.
To figure out your profit or loss, calculate the following:
Net Income = (Revenue + Gains) – (Expenses + Losses)
Income statements are the bread and butter for stakeholders. But they’re also very beneficial for you, as the owner or manager of your organization. Often, managers will make income statements on a departmental level to compare how each business area is functioning. If one department has more expenses than others, you can use this information to determine where the issue is and decide to correct it.
Perhaps you could improve training to increase sales. Or focus on increasing production capacity. It can even provide you the information needed to decide whether to shut a department down or discontinue certain products to improve the bottom line.
The cash flow statement gives a comprehensive view of how cash flows through the organization. Any (and all) cash flow activities are reported on this statement, such as operating, investing, and financing activities.
This statement will show potential stakeholders how well a business manages its cash flow and pays off its debt obligations. Where the organization’s money comes from and how they use it is what potential stakeholders are most interested in.
While the statement of cash flows complements the balance sheet and income statement, it’s important to note that this report is different from the others because it doesn’t consider any future income or expenses (accounts receivable or accounts payable).
You’ll find this report generally broken up into three different categories: cash from operating activities, cash from investing activities, and cash from financing activities.
Operating activities are sources linked to any of the company’s products or services, regardless of whether they’re an income or expense. They could include receipts from goods or services sold, operating expenses, employee payments, interest payments, etc.
Cash from investing activities is precisely as the name implies. Listed under this category is anything that comes from investing activities.
Cash from financing activities would include any payments from or to an outside financing organization. Loan repayments and payment of dividends are examples of what you might find listed under cash from financing activities.
Sometimes, a cash flow statement may appear as a negative cash flow. This isn’t necessarily a matter of concern. Some organization’s cash flow statements will appear this way because of expansions or other business moves that will benefit the company’s future. That makes it imperative that cash flow statements are not taken at face value and are thoroughly analyzed to determine your company’s financial health.
Now that we’ve established how vital these statements are to identifying your business’s financial position, it’s essential that we also touch on the importance of doing the actual bookkeeping. For the financial statements to do as they were intended, accurate bookkeeping is a must. Many small business owners choose to do this themselves. And while digging through piles of paperwork and receipts sounds like a blast, if you decide to do your company’s bookkeeping, accounting software would make your life a whole lot easier.
When it comes to accounting software, the best fit for your organization will be the one that is easiest to use and is most cost-efficient. Quickbooks is probably the most popular for both of these reasons. It allows you to input necessary data for your business and then generates the financial reports you need from there. Quickbooks will also help you to organize receipts, invoices, and payroll. You’ll find endless training material to help you navigate the software with ease. Even if you don’t have time to look into the training material, this software is pretty simple to navigate on your own. It makes bookkeeping a breeze.
Another option to investigate is Freshbooks. This software is also reasonably easy to use and can help you with bookkeeping regardless of the size of your business.
The great thing about both of these options is that they both come with a free trial period. So you can try them out at your leisure and choose from whichever one works best for you. (Of course, you can always just hire a CPA).
To grow your business, you need the tools necessary to make intelligent financial decisions. Your potential lenders and investors will also need these tools to determine if they want to take a chance with your business. With financial statements, your small business will be able to provide a snapshot of the health of your internal operations. While there is no surefire way to guarantee business growth, these statements will help you to analyze your financial position so that you can identify any red flags that might be holding you back.