Have you recently started your own business and are struggling with all the tasks and duties you need to keep up with to ensure your company survives and thrives? Being an entrepreneur is no easy task, but it can certainly be a rewarding one. One of the basic tasks you need to get a handle on to understand the ins and outs of your business is your financial statements. While they may seem complicated at first, with a little knowledge, you can use them to help you make informed decisions that drive growth. Here’s a guide on what financial statements are and how to understand them.
What Are Financial Statements?
Financial statements are records that provide a snapshot of a business’s financial performance and position. They need to be prepared on a monthly, quarterly, or annual basis and help you make key decisions on securing funds, managing expenses, and assessing the performance of your company. The three main statements you should be familiar with are P&L (profit and loss), balance sheets, and cash flow.
Why Entrepreneurs Should Care About Financial Statements
Understanding your financial statements is important for the following reasons:
- Informed Decision Making: Financial statements provide insights into areas of your business that need attention. By analyzing these reports, you can make more informed decisions regarding pricing, cost management, and investments.
- Securing Funding: Lenders, investors, and potential partners will review your financial statements to assess the risk and potential return on investment. Accurate and up-to-date financial statements make it easier to secure funding.
- Financial Forecasting: By tracking trends in your financial statements over time, you can predict future performance. This is especially helpful for budgeting, managing cash flow, and setting long-term goals.
- Tax Preparation: Financial statements are essential for tax reporting. They help you calculate your tax liabilities and ensure compliance with government regulations.
The Three Different Types of Statements
Profit and Loss Statement
The P&L shows your company’s revenues, costs, and expenses over a specific period of time. It tells you whether your business is making a profit or incurring a loss. Understanding this document is vital because it indicates your business’s profitability.
Key components of this statement include:
- Revenue/Sales: The total income generated from the sale of goods or services.
- Cost of Goods Sold (COGS): The direct costs associated with producing the goods or services sold by your business. For example, raw materials and labor.
- Gross Profit: Revenue minus COGS, showing how efficiently your business is producing and selling its products.
- Operating Expenses: These are costs not directly tied to production but necessary for running the business, such as rent, utilities, salaries, and marketing expenses.
- Net Income: The bottom line—revenue minus all expenses, taxes, and costs. This is the profit or loss your business has made during the period.
By properly creating and analyzing the P&L statement, you can determine whether or not you are achieving profitability and if you are managing your expenses correctly.
Balance Sheet
The balance sheet provides a snapshot of your business’s financial position at a specific point in time. It helps you understand the overall financial strength and liquidity of your business by explaining what you own and what you owe.
A balance sheet consists of three main sections:
- Assets: Everything the business owns that has value. This includes current assets (cash, accounts receivable, and inventory) and non-current assets (property, equipment, and intellectual property).
- Liabilities: What your business owes, including loans, accounts payable, and other obligations. These are classified into current liabilities (due within one year) and long-term liabilities (due after one year).
- Equity: The owner’s claim on the business after all liabilities are deducted from the assets. It includes retained earnings and any money invested by the owner(s).
The basic formula for the balance sheet is: Assets = Liabilities + Equity. This equation must always balance and it will tell you whether or not your company has enough assets to cover its liabilities.
Cash Flow Statement
The cash flow statement is one of the most important documents for entrepreneurs to track, as it shows how cash flows in and out of the business over time. Unlike the P&L statement, which focuses on profitability, the cash flow statement focuses on liquidity, or the ability to pay bills and reinvest in the business.
The cash flow statement is divided into three sections:
- Operating Activities: Cash generated or used in the day-to-day operations of the business. This includes receipts from customers and payments to suppliers and employees.
- Investing Activities: Cash flows related to buying and selling assets like property, equipment, or investments.
- Financing Activities: Cash flows from borrowing money, issuing equity, or paying back loans and dividends.
By reviewing the cash flow statement, you can gauge your ability to cover expenses, repay debt, and invest in future growth. A business with positive cash flow is more likely to weather economic challenges, while one with negative cash flow could face difficulties even if it’s profitable on paper.
Properly creating and understanding your financial statements is one of the most important tasks you can do to make your business successful. Need help preparing or interpreting your statements? The helpful experts at Hayes & Associates would be happy to help.
