A keen awareness of the financial health of your business is a prime concern for any business owner. It’s a signal of growth or of a need for change. It’s how you know you’re doing the right thing and making good choices. It provides valuable feedback that informs which direction the company should move. Financial health is also a signal to people outside of the business. Investors and creditors have a vested interest in the financial health of a business. So, what’s the best way to assess this? It’s by understanding business financial statements. A clear understanding of these statements will give you the tools to make the best decisions possible and provide you with a detailed understanding of your company’s financial well being.
What Are Financial Statements?
Financial statements are written documents for tax, investing, and financing purposes that are usually part of an annual report. They’re useful for everyone from business owners, accountants, government agencies, investors, and more.
They’re so useful because they provide valuable information regarding the:
- cash flow
- overall financial performance of a business
Since they provide a detailed account of the financial health of a business, they can therefore inform important business planning decisions. In addition, they can predict future financial performance.
There are three important basic financial statements, and each of them looks at a particular aspect of a company’s financial health.
The Three Main Business Financial Statements
1. Balance Sheet
A balance sheet is like a snapshot in time. It reports on the financial data as it is on the date of the report. The data it reports on are the assets, liabilities, and equity of the business.
The balance sheet uses a basic formula, or the Accounting Equation, shown below:
Assets = Liabilities + Shareholders’ Equity
These are anything of value that the company owns. It includes cash, inventory, investments, equipment, etc. It also includes money that customers owe to the company, under accounts receivable.
The report generally lists assets in order of liquidity, or how quickly they can be converted into cash. Current assets are those that the company expects to liquidate within a year. Noncurrent assets are those that the company doesn’t expect to liquidate within a year. This includes fixed assets, which are essential assets for operating the business that aren’t available for sale.
This category is the money that the company owes to others. Debts, rent, taxes, wages payable, and utilities are all liabilities. On the balance sheet, liabilities fall in the order that the company expects to pay them. Short-term or current liabilities are due within the year. And long-term or noncurrent liabilities have due dates that are more than a year in the future.
This is also sometimes called net worth. It is the company’s total assets minus its liabilities. And it represents the amount of money that the company would return to shareholders if it were to liquidate all of its assets and pay off its liabilities.
Balance sheets are uniquely beneficial in that they show how a company’s assets are funded. Is it through liabilities or through stockholder equity?
2. Income Statement
Income statements differ from balance sheets in that they represent a period of time rather than taking a snapshot of a company’s financial standing. Quarterly income statements show a company’s performance over a quarter and annual statements cover the entire year.
Also known as a profit and loss statement, an income statement essentially shows the revenue a company earned over a specific period of time. It also reports on business expenses and earnings per share. These often include two or three years’ worth of data for comparison. This is perhaps the most common of the three main types of financial statements.
The Net Income for the period of time uses the following calculation:
Net Income = Revenue – Expenses
There are two main types of revenue: operating revenue and non-operating revenue.
A business earns operating revenue through selling its product or service. Hence, it’s revenue that comes from the primary business activities.
Non-operating revenue comes from business activities that are not primary.
This could include:
- income from a rental property
- interest earned on deposited funds
- money from strategic partnerships
Most expenses generate from executing the core-activities of the business. Things like the cost of production, employee wages, administrative costs, and R&D all fall into this category. There are also secondary expenses that would from interest on loans or debt.
Earnings Per Share (EPS)
This is a calculation that shows how much money would go to shareholders if the company decided to distribute all net earnings for the period of the income statement. You would calculate it by dividing the total net income by the total number of outstanding shares in the company.
The primary function of an income statement is to show details regarding a company’s profitability over a period of time. So, in conjunction with past income statements, it’s an effective method for checking whether a company’s revenue is increasing or decreasing over time.
This financial statement also shows how well a company is managing its expenses, which is valuable information for investors.
3. Cash Flow Statements
We’ve looked at the importance of managing cash flow before. It’s an important indicator of your company’s financial health, and that makes cash flow statements extra valuable.
A cash flow statement shows a company’s inflows and outflows of cash. It provides a measure of how well a company generates cash to pay debts and fund operating expenses and investments.
It’s an important metric because a company needs to have enough available cash to pay expenses and purchase assets. It also gives more details about where money is coming from and how the company is spending it.
Unlike a balance sheet, a cash flow statement focuses on changes over time instead of a fixed dollar amount at a given time. It uses data from the balance sheet and income statement.
Cash flow statements typically have three main parts:
- operating activities
- investing activities
- financing activities
This is the first part of a cash flow statement, and it analyzes the cash flow from net income and losses. It looks at all financial activities for operating the business and selling its product or service.
This includes cash from:
- accounts receivable
- accounts payable
These are activities resulting in a cash inflow or outflow for investment in the future of the company. Investing activities include things like the purchase or sale of assets and loans.
For example, if a company used cash to purchase a new building to increase production, this expense would show as a cash outflow in investing activities. Likewise, if a company decides to sell an investment, the proceeds count as a cash inflow from investing activities.
Cash flow from financing activities includes activities like the sale of stocks or bonds to raise cash. It also includes money that the company borrowed from banks.
Each financial statement also includes footnotes that provide a lot of quality information. Becoming familiar with these footnotes will give you even more insight. Two common footnote categories are income taxes and stock options.
This section of the footnotes details the income tax information of the company. It breaks down current and deferred income tax information by government level (federal, state, local). Plus, it describes the main items that affect the company’s tax rate.
This is where you’ll find information on the stock options available for officers and employees.
Valuable Insight with Limitations
Financial statements are a central component in understanding your company’s financial position. For giant and small business alike, they offer valuable insights to people inside and outside of your company.
You can use the financial reports to:
- evaluate the current financial health of your company
- look for trends in your performance
- make decisions based on future projections
However, the use of financial statements isn’t without limitation. As with most things in life, what the numbers in financial statements mean is up to interpretation. Even with the same data, it’s common for investors to come to very different conclusions.
For this reason, it’s important to use as much data as possible to form the most comprehensive picture of your financial position. This can mean drawing from past financial statements and comparing numbers with competitors in the same industry. It can also mean seeking expert guidance is the right thing to do. Sometimes it takes an experienced third party to make a clear evaluation. In any scenario, understanding your business financial statements is a key piece of the puzzle.
Take the Time to Understand Your Business
Make sure your business is and remains viable. Take the time to truly understand where it stands financially. Take into consideration all of the information you have at your disposal, more than just the amount of profit you’ve created. Nothing will put you in a better position to succeed than the best understanding of your own business’s financial health.
At Saddock Advisory, we can help determine if your business is financially healthy. Get in touch with us here to find out more.