Understanding Financial Statements

(Last Updated On: May 10, 2021)

Lesson 5 in the Basic Accounting series:

Understanding financial statements are one of the keys to your small business success because the statements are a reflection of the company’s financial performance and the company’s financial health.

Sadly, many entrepreneurs fail not because they lack knowledge of their products and determination…

but, because they failed to realize the importance of preparing and analyzing their financial statements and financing activities.

Analyzing And Understanding Financial Statements:

Financial statements are the main way to report financial information to people within your organization, such as management and employees, and to people outside your organization such as banks, investors & financial analysts, suppliers, and others. Investors and financial analysts will look at working capital, operating margin, and debt obligations to analyze the stability and future of the business.

For example, a small excavating company significantly increased sales for three straight years then failed. The reason why? They overspent on equipment and overextended themselves by offering loose credit terms and discounts.

You can avoid these cash flow traps by simply taking the time to analyze your financial statements by looking for financial trends.

 

The main three financial statements for small businesses are the Profit and Loss Statement (income statement), the balance sheet, and the statement of cash flows or cash flow statements.

The order in which the statements are normally prepared and the nature of the data presented in each statement are as follows:

  • Profit and Loss Statement (Income Statement) — a summary of the revenue and expenses for a specific period of time, such as a month or year including depreciation, amortization, operational expenses, net income, gross profit,
  • Accounting Balance Sheet — a list of the assets (current assets, long-term assets, intangible assets such as patents & goodwill, total assets), liabilities (current liabilities, short term liabilities, long term liabilities, total liabilities), accounts receivable, dividends, and owner’s equity and shareholders’ equity as of a specific date, usually at the close of the last day of a month or a year. This includes inventory,
  • Statement of Cash Flows — a summary of the cash receipts and cash payments for a specific period of time, such as a month or a year

All three financial statements should be identified by the name of your small business, the title of the statement, and the date or period of time.

The data presented in the profit and loss statement and the statement of cash flows is for a certain period of time. The data presented in the balance sheet is for a specific date.

Note: If you have a very small business, a profit and loss statement and a balance sheet are usually all that is required or needed.

Your retained earnings data, which shows your profits or losses from the first day of your business to the present are shown on your balance sheet in small businesses. In larger businesses, this data is detailed in a separate report called a Statement of Owner’s Equity.

A statement of owner’s equity a summary of the changes in the owner’s equity that occurred during a specific period of time, such as a month or year. It is also called a Retained Earnings Statement.

Understanding financial statements are not rocket science. Most small business owners have basic financial information on their financial statements. So learn basic accounting principles and gain a basic understanding of how to prepare and read financial statements.

Also, understand the importance of generating and analyzing financial statements and see what investing activities investors look for in your statements in this article: Financial Statements for a Small Business. Investing activity includes the cash flow from the purchases or sale of assets.

This information will help you with your day-to-day financial decisions in your business and help you in your quest for financial success.

 

Next Section: Lesson 6

Financial Ratio Analysis

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