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Financial Reports Every Small Business Owner Should Understand

Two pieces of paper that are a business's financial reports lay on top of each other. The one on top says Income Statement and partially obscures the other. A pen juts out from the lower left of the photo. The paper on top says Income Statement and has lines for Revenue, Sale revenue, Sales, Cost of goods [sold], and Gross profit.

If you run a business, eventually, someone will ask to see your financial statements. What they mean is they want to see your balance sheet, your income statement, and your cash flow statement. These financial reports are supposed to give you a snapshot of how your business is doing. But, if you understand how they’re put together, you know that they can miss quite a lot too. In this article, we’ll go over how to read the balance sheet, the income statement, the cash flow statement, and a few other related documents. More importantly, we’ll show you what these financial reports don’t tell you.

This article is part of our series on how to set up an accounting system, for small businesses. We covered some basic accounting vocabulary and concepts in an earlier article. If you’re a total accounting newbie and if you haven’t done so already, we encourage you to check out the vocabulary and concepts article before you read this one.

Our goal with these articles isn’t to transform you into an accounting guru. If you need guru-level help, you should hire a CPA. We just want to give you enough information to get by. This way, you can keep your books with the help of accounting software and focus most of your time on all the other aspects of running your business.

Let’s start with probably the most important financial report for understanding your business: the balance sheet.

The Balance Sheet Gives You an Overview of a Business’s Worth

The balance sheet gives you an overview of how much your business is worth. In an earlier article, we said the total worth of your business is equal to everything your business owns minus everything your business owes. In other words:

Equity = Assets – Liabilities

Your balance sheet is a listing of this formula, except your assets are listed first, then your liabilities, and last your equity. There’s always a date on the balance sheet, because the numbers might look different on a different date.

The Information You’ll Find Under Each Section

Under the big sections of assets, liabilities, and equity, usually there’s a list that breaks down the information a little further.

For assets, you’ll usually see both tangible and intangible assets broken down into subcategories like:

  • Cash
  • Inventory
  • Accounts receivable
  • Equipment
  • Land/building
  • Intellectual property

Liabilities can be further divided into:

  • Payroll
  • Accounts payable
  • Rent
  • Utilities
  • Loan

Equity is usually the last section of an income statement. If your business is a corporation, you’ll see a line called shareholder’s equity. If you’re a sole proprietorship or a single-member LLC, the line is owner’s equity. And, if you’re a partnership or a multi-member LLC treated as a partnership, then you’ll see partner capital. This number shows how much the business is worth. It includes the money the owner, partners, or shareholders paid to get their ownership of the business.

You’ll also see a line called retained earnings. This is the profit the business keeps to run the business instead of passing out to the owners/partners/shareholders.

There’s always a date on the balance sheet. This means that the numbers are accurate as of that date.

Information Hidden by Your Balance Sheet

While the balance sheet gives you a general overview of the state of a business, the numbers can be massaged to make the business look better or worse than it actually is.

For example, there are several perfectly acceptable ways to valuate your inventory. In most industries, the cost of your raw materials can fluctuate. As you use up your raw materials, should you calculate your COGS using the lower cost batch or the higher cost batch? The method you pick will affect your COGS.

Another example involves valuating your business’s intellectual property. IP is notoriously difficult to valuate for lots of reasons. A lot of businesses simply leave IP off their financial reports. But other businesses—usually very large ones with lots of IP—form IP licensing subsidiaries to store their IP. In the process, they’re able to set a value for their IP and show it in their balance sheet.

So, while the balance sheet does give you quite a bit of information about the state of a business, it doesn’t tell you everything. A skilled accountant can use perfectly legitimate ways to raise or lower various numbers, within reason.

The Income Statement Gives You an Idea of Your Profits

The income statement is another very important financial report you should understand. This report basically tells you your profits on the date you run your report. Because it gives you an idea of your profits, the income statement is sometimes also called a profit and loss statement.

Information Included in the Income Statement

The income statement is based on the formula:

Net Income = Total Revenue – COGS – Operating Expenses – Non-Operating Expenses – Taxes

Each of these terms mean:

  • Total revenue: All the money you bring in from the sale of your goods or services.
  • Cost of goods sold (COGS): All the costs that go into the manufacturing of your goods. This includes all the payroll for your production personnel, rent for your manufacturing facility, utilities for your manufacturing facility, your raw material costs, your packaging costs, any commission you pay for your sales personnel, and similar. If you pay rent for a large area and some part of that area houses your manufacturing facilities and other areas house your office support staff, you can technically break down your rent and attribute some of that to your COGS. If you’re a wholesale or retail business, then your COGS include the cost of buying, packaging, storing, and selling your goods.
  • Operating expenses: All your expenses that do not go into your COGS. Typical example of operating expenses include payroll for non-manufacturing staff, insurance, rent, research and development, license fees, marketing, building repairs, office supplies, utilities, property taxes, travel expenses, depreciation, amortization, and similar.
  • Non-operating expenses: Expenses not related to your day-to-day business activities. Usually, non-operating expenses include interest on loans, costs from currency exchange, losses on disposition of assets, charges on obsolete inventory, lawsuit settlement costs, costs on business restructuring, and some others.

Terms Related to the Income Statement

In financing, a lot of terms mean slightly different things. You can get quite a few flavors of income from the financial statement, with each having a slightly different meaning. Since you’ll often see these variations, we list them and their definitions below:

Gross profit = total revenue – COGS

Operating income = gross profit – operating expenses

Income before taxes = operating income – non-operating expenses

Net income = income before taxes – taxes

Your Income Statement Can Look Different, Depending on Various Factors

Like your balance sheet, your income statement gives you a general idea of your profits as of the date of the report. And, like your balance sheet, the numbers on the income statement can be massaged to show a higher or lower profit.

For example, there are several acceptable formulas for depreciating equipment. Your equipment can be a part of your COGS. So, the formula you use can increase or decrease your COGS. The cost of your raw materials can also fluctuate. Depending on how you keep track of these costs, this can affect your COGS as well. Other methods of keeping track of your spending can apply to operating expenses and non-operating expenses. In the end, all of this can affect your net income, and you won’t know how they affect the net income unless you dig into the details.

The Cash Flow Statement Gives You an Idea of How Much You Have in the Bank

The cash flow statement is the third of the three most important financial reports for a business. This report gives you an overview of how much cash you have on hand at a given moment.

How to Construct Your Cash Flow Statement

Your cash flow statement can be simple or complicated. And it depends on the accounting method you picked when you started your books.

If you picked the cash accounting method, then your cash flow statement is really simple. You don’t have to deal with depreciation/amortization. Your income and expenses are recorded only when they come in or when you pay out. So, without making any adjustments, the cash in your books should be the same as the cash you have in your bank account(s).

But if you picked the accrual method, then your cash flow statement is a little trickier. To find out how much cash you actually have on hand, you have to subtract the amounts in your accounts receivable and add the money in your accounts payable. And, if you have any depreciated or amortized assets, you have to subtract them from your cash too.

Basically, you have to adjust your accounts receivable because the money is already counted as revenue. But you don’t have the cash yet. You have to adjust your accounts payable because you’ve recorded the amount as money you’ve already spent. But you haven’t actually paid out the money yet.

Lastly, you have to adjust for depreciation and amortization. Accounting rules make you recognize this spend over a long period of time, even though you’ve paid all the money already. So, you have to take the amount not already depreciated or amortized and subtract that from your total for cash. Subtracting all the undepreciated or unamortized amount adjusts for the fact that you’ve already paid for the item(s).

Once you make these three major adjustments, you get a number that should tell you exactly how much cash your business has on a given date.

How Information is Presented in the Cash Flow Statement

The cash flow statement is presented in three sections:

  • Cash flow from operating activities
  • Cash flow from investment activities
  • Cash flow from financing activities

Our readers are small business owners, so most of your cash flow statement will focus on cash flow from operating activities. You’ll likely have little to no investment activities because most small businesses like to take the cash out of the business to pay its owner(s) fairly quickly. You might have some cash flow from financing activities like a loan, but this will be limited compared to the cash flow from operating activities.

What a Cash Flow Statement Won’t Show

Like the other financial reports, the cash flow statement gives you a fairly good idea of your business’s cash flow at a given time. But, like the other reports, because you have to account for items such as depreciation, the numbers on the report can be a little off here and there.

The General Ledger is Used to Construct the Financial Reports

Other than the three financial reports already discussed, you should know about a couple of other documents used in bookkeeping. First, there is the general ledger.

Every transaction a business makes is first entered into the general ledger. Then, to construct the balance sheet, the income statement, and the cash flow statement, you pull all the needed information from the general ledger.

To organize this many transactions, the general ledger is divided into categories. Usually, these categories follow the categories in the balance sheet and the income statement. So, you’ll have the categories: assets, liabilities, equity, revenue, and expenses.

The big categories are typically further broken down into sub-accounts. For example, under assets, you can have the sub-accounts: accounts receivable, inventory, checking account, savings account, and petty cash. Under liabilities, you can have: accounts payable, sales tax payable, payroll tax payable, and similar. You can break the equity, revenue, and expenses accounts into similar sub-accounts.

There are no real rules on how many or even how you name each sub account. The ones we mention are typical ones, but you can often name your own.

The Chart of Accounts is an Index of All the Sub-Accounts in the General Ledger

Of course, when you have lots of sub-accounts, eventually you won’t be able to remember them all. This is why we have a chart of accounts. The chart of accounts is an index of all the sub-categories in your general ledger, so you can be consistent when making journal entries.

In modern accounting software, usually, you’ll have a default chart of accounts ready-made for you. You can add your own accounts if you wish. This way, you can monitor specific sub-accounts more closely. For example, you can break your inventory sub-account into raw materials and packaging materials if you wish to track them more closely.

Aging Reports Show You What is Due and What is Late

When you use accounting software, you’ll often be able to generate aging reports to show you when a payment is due or when you should be receiving a payment. There are two types of aging reports: the accounts receivable aging report and the accounts payable aging report.

The accounts receivable aging report shows you when you should expect payment from your customers. More importantly, they show you when a customer is overdue in payments.

The accounts payable aging report shows you when you need to pay out. Often, the report will also show you any discounts from your vendors if you pay early and any penalties you’ll have to pay if you pay late.

These two financial reports are good to have and good for you to check early and often, of course.

Accounting Software Automates Financial Report Generation and Data Entry

It’s important for a small business owner to have a high-level understanding of a business’s financial reports and bookkeeping documents. And, for centuries, these reports were compiled by hand and only generated once per quarter.

But accounting software has made data entry and financial report generation very easy. Often, you’ll either sync the data with other software or upload a data file to your software. Then the software automatically populates the reports for you.

So, as a business owner, you no longer need to understand how to make individual entries into a general ledger. You also won’t need to know how to generate financial statements. Everything is automatically done for you.

All that’s left is for you to understand what the reports tell you—and don’t tell you. Which, we hope, this article has explained.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

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