Fundamentals of Financial Statements

Running a small business is challenging, and time is always precious. That’s why understanding your financial statements is not just important – it’s essential for your success. Financial fundamentals can help you prepare for capital and guide your business in the right direction. This article will help you grasp the essentials of financial documentation without spending countless hours deciphering complex jargon. You’ll learn how to create a profit and loss statement, financial projections, cash flow statement, and a balance sheet in a way that’s straightforward and time-efficient.

We believe it doesn’t take an accounting wiz or a math genius to get a few core pieces in place that will set your business up for long-term success. Gain the knowledge and tools to make informed decisions, identify opportunities for growth, and steer your business with confidence.

 

 

Meet the Experts

Andrew Morse

Andrew Morse is a Senior Vice President at Global Atlantic, a leading annuity and life insurance company.  Andrew began his career as an auditor for PricewaterhouseCoopers for 5 years, was controller for the not-for-profit company BELL Excel for an additional 6 years, and most recently has held various roles, all in financial reporting, or planning and analysis, at Global Atlantic for the past 10 years.  In his current role, Andrew leads a large team and collaborates frequently with various functions and customers inside and outside of the company.

Oren Shani

Oren Shani is a credit advisor and certified business coach with Accion Opportunity Fund. Oren has 10+ years of experience managing businesses and advising other business owners. He started, managed, and expanded his own business, providing disability accommodations for live events across the country. He now helps entrepreneurs launch and grow their own businesses.

Importance of Good Bookkeeping Practices

Many entrepreneurs and small business owners are so busy running the day-to-day operations of a business that they don’t always have time or bandwidth to work on growing their business. Small business owners who develop the skill set to take a step back and work on their business are better able to meet their business goals. 

Implementing an organized financial management system has many benefits: 

• Frees up time
• Reduces stress​ 
• Set up for quicker customer payments
• Pay vendors on time
• Eases financial reporting​ 
• Simplifies taxes​ 
• Informs strategic decisions​ 
• Attracts lenders/investors​ 

There are many tools you can use to help you implement an organized financial system, including apps and software programs.

Fundamental Financial Statements For Small Businesses

Financial statements are crucial tools for understanding the financial health of your business. Let’s explore the basics of financial statements, including understanding profit and loss, balance sheets, and cash flow statements.

Profit and Loss

What is a Profit and Loss Statement?

A profit and loss statement, also known as an income statement, provides a summary of your business’s revenues, expenses, and net income over a specific period. It helps you track the profitability of your business operations within a given timeframe. Understanding your profit and loss statement is crucial for assessing your business’s financial health and performance. Let’s delve into the various aspects of the profit and loss statement:

 

How to Make a Profit and Loss Statement for Small Business

The basic formula for a profit and loss statement is Revenue – Expenses = Net Income. Here’s what goes into each of those figures:

Revenue:

• Include all sources of income, such as sales, services rendered, and interest earned.
• Break down revenue by product or service category for better insights.

Expenses:

• Categorize expenses into fixed (e.g., rent, salaries) and variable (e.g., utilities, raw materials).
• List operating expenses, including marketing, utilities, rent, wages, and supplies.
• Include non-operating expenses like interest payments and taxes.
• Includes both direct and indirect expenses.

Subtract total expenses from total revenue to determine net income. A positive net income indicates profitability, while a negative net income signals losses.

 

How to Use a Profit and Loss Statement for Small Business

Performance Evaluation:

• Analyze trends in revenue and expenses to identify areas of strength and weakness.
• Compare current results with past periods to gauge business growth or decline.

Decision Making:

• Use insights from the profit and loss statement to make informed decisions about pricing, cost-cutting, and investment.
• Adjust business strategies based on profitability trends to maximize earnings.

Financial Planning:

• Forecast future revenue and expenses based on historical data to develop realistic budgets and financial goals.
• Set benchmarks for revenue targets and expense control measures.

Key Profit and Loss Calculations

Key calculations include gross profit margin, net profit margin, and earnings before interest, taxes, depreciation, and amortization (EBITDA). You can use these calculations to give you a quick check of the financial health of the business.

Gross Profit Margin:

• Formula: Gross Profit Margin = (Gross Profit / Revenue) * 100
  • Gross Profit: Gross Profit = Revenue – Cost of Goods Sold
• Definition: Gross Profit Margin measures the percentage of revenue that exceeds the cost of goods sold.

Operating Profit Margin:

• Formula: Operating Profit Margin = (Operating Profit / Revenue) * 100
  • Operating Profit: Operating Profit = Gross Profit – Operating Expenses
• Definition: Operating Profit Margin indicates the percentage of revenue remaining after deducting operating expenses.

Net Profit Margin:

• Formula: Net Profit Margin = (Net Profit / Revenue) * 100
  • Net Profit: Net Profit = Revenue – Total Expenses
• Definition: Net Profit Margin represents the percentage of revenue that remains as net profit after accounting for all expenses.

Understanding the components and insights provided by your profit and loss statement empowers you to make informed decisions and steer your business towards sustainable growth and profitability.

 

Balance Sheets

What is a Balance Sheet?

A balance sheet provides a summary of what your business owns (assets), owes (liabilities), and its net worth (equity) at a given moment. It follows the fundamental accounting equation: Assets = Liabilities + Equity.

 

How to Make a Balance Sheet for Small Business

Compile a balance sheet by listing your assets and liabilities. Then, subtract liabilities from assets to calculate your equity.

Assets:

• List current assets (e.g., cash, inventory, accounts receivable) and long-term assets (e.g., property, equipment, investments).
• Classify assets based on liquidity, with current assets being more liquid than long-term assets.

Liabilities:

• Include current liabilities (e.g., accounts payable, short-term loans) and long-term liabilities (e.g., mortgages, bonds).
• Categorize liabilities by due date and interest rate to assess repayment obligations.

Equity:

• Calculate equity by subtracting total liabilities from total assets.
• Equity represents the owner’s stake in the business and can include retained earnings and capital contributions.

How to Use a Balance Sheet for Small Business

Use the balance sheet to assess your business’s financial health, monitor changes in assets and liabilities, and evaluate your capital structure. It can help you make strategic decisions and secure financing.

Financial Health Assessment:

• Evaluate liquidity by comparing current assets to current liabilities. Liquidity is important when it comes to your business’ ability to respond to emergencies and jump on opportunities.
• Assess business long term ability to meet it’s financial obligations by analyzing the debt-to-equity ratio and debt coverage ratios.

Investor and Creditor Relations:

• Share the balance sheet with investors and creditors to demonstrate financial stability and creditworthiness.
• Use the balance sheet to negotiate favorable loan terms or attract potential investors.

Strategic Decision Making:

• Identify areas for growth or cost reduction by reviewing asset composition and debt levels.
• Make informed decisions about financing, investment, and business expansion based on balance sheet insights.

Key Balance Sheet Calculations

Key calculations include the debt-to-equity ratio and the current ratio:

Current Ratio:

• Formula: Current Ratio = Current Assets / Current Liabilities
• Definition: Current Ratio measures a company’s ability to cover short-term liabilities with its short-term assets.

Debt-to-Equity Ratio:

• Formula: Debt-to-Equity Ratio = Total Liabilities / Total Equity
• Definition: Debt-to-Equity Ratio assesses the proportion of debt used to finance the business compared to equity.

A thorough understanding of your balance sheet enables you to gauge your business’s financial strength, make strategic decisions, and maintain healthy relationships with stakeholders.

 

Cash Flow Statements

What is a Cash Flow Statement?

The cash flow statement records cash inflows and outflows from operating, investing, and financing activities. It highlights changes in cash balances and helps assess the business’s ability to generate and manage cash. Cash flow statements are also used as the basis for many financial projections. Here’s a closer look at the components and utility of the cash flow statement:

 

How to Make a Cash Flow Statement for Small Business

Prepare a cash flow statement by categorizing cash inflows (such as sales revenue and investments) and outflows (such as expenses and loan payments). You can use accounting software or templates to make this process easier.

Operating Activities:

• Record cash receipts and payments related to core business operations, such as sales, purchases, and expenses.
• Adjust net income for non-cash items like depreciation and changes in working capital.

Investing Activities:

• Document cash transactions associated with the acquisition or sale of long-term assets, investments, and loans.
• Include purchases of property, equipment, and securities, as well as proceeds from asset sales.

Financing Activities:

• Capture cash flows from borrowing, repayments, equity financing, and dividend payments.
• Record proceeds from loans, issuance of stock, and dividends paid to shareholders.

How to Use a Cash Flow Statement for Small Business

Use the cash flow statement to manage cash flow effectively, identify cash shortages or surpluses, and plan for future financial needs. It can also help you make informed decisions about investments and financing.

Cash Management:

• Monitor cash inflows and outflows to ensure sufficient liquidity for daily operations and planned expenses.
• Identify periods of cash surplus or shortage and adjust spending or financing activities accordingly.

Financial Planning:

• Use cash flow projections to anticipate future cash needs and plan for contingencies or expansion.
• Evaluate the impact of different scenarios on cash flow, such as changes in sales volume or operating expenses.

Key Cash Flow Statement Calculations

Key calculations include operating cash flow (cash generated from core business activities), investing cash flow (cash used for investments), and financing cash flow (cash from or used for financing activities).

Operating Cash Flow:

• Formula: Operating Cash Flow = Net Income + Non-cash Expenses – Changes in Working Capital
• Definition: Operating Cash Flow represents the cash generated or used by the company’s core operations.

Free Cash Flow:

• Formula: Free Cash Flow = Operating Cash Flow – Capital Expenditures
• Definition: Free Cash Flow measures the cash remaining after accounting for capital expenditures necessary to maintain or expand the business.

Mastering your cash flow statement empowers you to optimize cash flow, plan for future financial needs, and maintain financial stability in your business operations.

 

Financial Statement Calculations and Ratios

Calculations and ratios from financial statements are powerful tools to drive business decisions and prompt action, especially when compared over time. There are a lot of financial ratios and key calculations out there and it is easy to get overwhelmed by the number of different financial ratios. However, not all ratios are relevant to your current business goals. Identify the two or three ratios that are most relevant to your current state of business and business challenges and follow those closely. An accountant, bookkeeper, or business coach should be able to help you identify the most relevant ratios and calculations for your current business needs.

 

All Financial Statements are Important

Understanding financial statements is essential for all business owners. However, it’s common for many business owners to initially focus only on the profit and loss statement, often discussing revenue and expenses. It’s essential to recognize that all the financial statements are interconnected and influence one another. Knowing and understanding each one is imperative. For instance, the cash flow statement acts as a vital tool for monitoring the ins and outs of your business’s cash, which is the fuel for your business operations. Meanwhile, the balance sheet provides valuable insights into your business’s assets, liabilities, and overall financial health, enabling informed decisions to foster growth and expansion. Examining your business’ financial health means looks at all of the financial statements wholistically, empowering you to make sound financial decisions and drive your businesses toward success. By mastering the fundamentals of financial statements, you can effectively manage your business’s finances and achieve your goals.

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