Working with a bookkeeper or CPA to create financial statements is essential for understanding your business finances. However, if you don’t know how to read financial statements, they’ll be useless when it comes to your business forecasting or future sales.
In this piece, you’ll learn how to analyze 3 common financial statements so you can better understand the state of your business and what’s to come.
If you need help with managing your finances,
contact Larry L. Bertsch, CPA & Associates, LLP today!
Understanding Financial Statements and How They Help
Financial statements provide insight into how your business operates in a clear, objective manner. Analyzed separately, different financial statements will provide snapshots of your business’s financial health. But when analyzed as a unit they display the full picture and provide vital information that businesses can use to strategize and grow for years to come.
Financial statements can tell you a number of things, including:
- How a business generates revenue
- How much revenue is being generated by the business
- The cost of doing business, and
- Information about the business’s cash management, assets, liabilities and more.
This information can then be used to:
- Help business owners identify current financial performance and predict future trends
- Create a clear picture for potential investors who may want to invest in your company, and
- Guide business owners to adjust their organizational strategy.
Without financial statements to understand the current state of your business, it’s impossible to create a realistic financial forecast. We will now look at the three most important financial statements: the balance sheet, income statement, and cash flow statement.
How to Read a Balance Sheet
A Balance Sheet communicates the worth of a business or organization. It includes the following data points of business finances:
- The company’s assets
- The company’s liabilities
- The owner’s equity
- A tally of all of the above.
This information will be given as a snapshot in time, using a “reporting date.” Depending on the frequency requirements of the company or the government, the balance sheet is typically prepared and distributed quarterly or monthly.
The balance sheet is used differently depending on who is looking at it.
Internal reviews are done by the owner of the company, a key stakeholder, or an employee. Depending on what the balance sheet says, they may see a need to change their approach or direction or identify successes and double down on what’s working well.
Alternatively, external reviews are done by an individual or entity interested in investing in or purchasing the company. Investors will use the business’s balance sheet to assess profitability and the debt-to-equity ratio for the business. If they like these two figures, they may choose to get involved. If they don’t, they’ll likely pass on the investment opportunity.
The Balance Sheet Equation
Before a balance sheet is ready to be analyzed, it’s important to double check the balance sheet for data errors. To do this, you’ll use a Balance Sheet Equation. The most common formula (though there are others) is:
Assets = Liabilities + Owner’s Equity
This means that the assets (anything owned by the company that could be converted to cash) must be equal to the liabilities (any financial or legal obligations to pay an amount of money to a debtor) plus the owner’s equity (aka Shareholder’s Equity, is anything belonging to the owner after liabilities have been paid).
These numbers must balance, or something has been figured incorrectly. If you find this to be the case, you’ll need to revisit your financial data to find any discrepancies that could be causing the issue.
How to Read an Income Statement
You may hear an Income Statement referred to as a Profit & Loss Statement (P&L). This financial statement includes:
- Income and expenses
- The cumulative impact of revenue, gain, expense and loss transactions.
This information is gathered over a given period allowing it to show financial trends over time. P&L Statement are typically shared quarterly or annually, depending on the business’s preference or need.
When combined with an annual report, the cash flow statement, and the balance sheet, you can see:
- If your business is generating profit
- If more money is headed out the door than is coming in
- The cost of production, and
- What cash is available to invest in the business’s future.
How to Analyze an Income Statement
You can perform your Income Statement analysis in two ways:
Vertical Analysis – each line is listed as a percentage instead of an exact amount. For example, you’ll see a percentage of gross sales within a current period. This is helpful for internal reviewers as it allows you to see whether metrics are improving.
Horizontal Analysis – most often expressed as a dollar amount over multiple reporting periods. This type of analysis is very useful for external reviewers as it shows trends and how the business grows over time.
Utilizing both methods will give you the most complete picture of your business and is the most robust of the business forecasting methods.
How to Read a Cash Flow Statement
Much like the previous two financial statements, a Cash Flow Statement is also useful to both the business owner for internal purposes, such as adjusting strategies or managing budgets and the potential investor for external purposes, like making investment decisions.
Cash Flow Statements include three sections:
- Operating Activities – revenue and expenses generated while delivering goods and services
- Investing Activities – cash flow generated from purchasing or selling assets
- Financing Activities – cash flow generated during debt and equity financing
How to Calculate Cash Flow
Cash Flow is calculated in one of two ways:
The Cash Flow Statement Direct Method takes all cash collections resulting from operating activities and then subtracts any of the cash disbursements resulting from those operating activities during a specific time period.
Alternatively, the Cash Flow Statement Indirect Method uses accrual accounting and adjusts net income by adding or subtracting non-cash items. This is more commonly used as it takes less time and most businesses already use accrual accounting.
Reviewing Cash Flow Statements provides necessary insight into your business. They can identify what phase your business is in (startup vs. mature and profitable) and whether your business is thriving or in a state of decline. This is generally described as Positive (or Negative) Cash Flow, meaning that during a set period of time, your cash inflow or outflow is higher.
Keep in mind, a negative cash flow doesn’t necessarily spell trouble and it could be indicative of the company choosing to expand and invest in the future.
This information can be used by an investor to gauge risk or by a manager to budget, or hire or fire employees.
Protect the Financial Health of Your Business with Accounting, Tax, and Business Services with Larry L. Bertsch, CPA & Associates
You already know the importance of tracking your business expenses and income to better understand the financial health of your business in the present moment and to prepare for the future. However, to get the full benefit of this knowledge, you must learn how to analyze financial statements and understand what they mean for the overall financial health of your business.
At Larry L. Bertsch, CPA & Associates, we want to help you make the most out of your financial data so you can make smart decisions for your business. Contact us today, and let us provide you with the insight you need.