Reading financial statements may be foreign to many people, but they tell you various stories about the money in your business. They're like reading nutrition labels -- you understand it better as you pick up new information. Financials statements provide you with a snapshot on where the money comes from, where it goes and where it is today.
Businesses will find value in having the following financial statements:
- Balance sheets.
- Income statements. (Sometimes referred to as profit and loss.)
- Cash flow statements.
Creating just one or two won't give you the whole story of your business finances. Each statement has its own role and story to tell, yet they overlap. Changes in assets and liabilities from a balance sheet appear in revenues and expenses on the income statement. Cash flow statements have more information about cash assets found in the balance sheet and relate to the net income in the income statement.
A balance sheet tells your company's life story of what your business owns (assets), what it owes (liabilities) and its net worth (shareholder's equity) from day one of operation to the date on the balance sheet.
On the balance sheet, assets go on the left side while liabilities and shareholder's equity appears on the right. After adding everything, the numbers on the left and right should be the same, thus balanced using the following formula:
ASSETS = LIABILITIES + SHAREHOLDERS' EQUITY
A balance sheet's value comes in showing how much the company owes and who owes the company. It can also tell how a company changed over the years, how it's financially managed and how the company did it.
For example, a hot company could show low or negative retained earnings (sum of company's profits since day one) because it had to pump a lot into the business to see success. A balance sheet can show what assets help the company generate cash and how it paid for those assets whether it was through loan or other funding.
An income statement shows how much your company earned and the costs and expenses for earning that revenue.
Let's say you look at an income statement for the previous year. You begin with the amount of money your company brought in through sales. These are your gross earnings. You may sell a part for $100, but that doesn't mean $100 profit. You still have to pay expenses that allowed you to obtain or make that part.
Gross earnings don't reflect the total amount your company has because it needs to pay operating expenses, subtract asset wear and tear (depreciation) and deduct taxes. Thus, you work your way down the line, deducting expenses for keeping the business running.
By the time you get to the bottom ("bottom line"), you'll see how much the company earned or lost for the year. This is your company's net earnings -- what the net catches after filtering everything else.
Cash Flow Statements
Cash statements focus on the cash that goes in and out of the business. A cash flow statement organizes the cash activities into three categories: operating, investing and financing activities. It uses data from the balance sheet and income statement, but in a different way.
Unlike income statements, cash flow statements don't consider incoming and outgoing cash the company hasn't recorded. This is because earnings and cash aren't the same thing.
Here is an example illustrating the important difference between earnings and cash.
You sell oilfield parts for $1 million with the agreement you will receive the full amount within one year. This deal appears in your income statement as $1 million in earnings. However, your bank account doesn't yet have $1 million. Therefore, the cash flow statement won't reflect this deal. Because you don't have the cash from the sale, you can't rack up $1 million in expenses.
An income statement could show profit and the company could still go bankrupt by spending the $1 million before it's available. Accounting tricks can't fake cash flow.
What questions do you have about these financial statements? What advice do you have for creating and reading financial statements?