Reading your Financial Statements (3 of 3)
There are three major financial statements, the Balance Sheet, Income Statements (sometimes referred to as Profit & Loss), and the Statement of Cash Flows. A fourth financial statement, the Statement of Shareholders Equity isn’t regularly prepared for a small business because there usually aren’t multiple classes of shareholders, and unrealized gains and losses typically aren’t tracked. The Statement of Shareholders’ Equity is basically an addendum to the Balance Sheet.
The purpose of financial statements is report financial data to interested parties in concise and uniformed way. Interested parties include lenders, investors, shareholders, management, and anyone else who needs to know how a business is doing.
The first financial statement, and probably the most telling, is the Balance Sheet. The Balance Sheet’s job is to show a company’s financial position on a specific date. As the name implies, the Balance Sheet, must balance! In order to balance, the Balance Sheet follows the accounting equation Assets equal Liabilities plus Equity.
An asset is a resource with economic value that your company owns or controls and that will provide future benefit. Another way to put this is that an asset is anything that your company has or that is owed to it. Examples of Assets are: Cash, Accounts Receivable, Inventory, Fixed Assets, and Investments.
A Liability is something your company owes to another party. Examples of Liabilities include: Accounts Payable and Debts owed.
Equity is the net assets attributable to the owners. Examples of Equity accounts include: Common Stock, Additional Paid-in Capital, and Retained Earnings. Retained Earnings is an account accumulates.
Here’s a common format for a balance. Assets are typically shown first and in order of liquidity (liquidity is how easily something can be converted into cash). Assets are then summed up so they can be compared to Liabilities plus Equity. Sometimes you’ll have sub-categories like current assets and noncurrent assets, each with their summed balance, but you’ll ALWAYS have a Total Assets line.
Liabilities are shown next, typically shown in order of due date. Similar to assets you can have sub-categories liked short-term liabilities and long-term liabilities.
Finally you have your Equity section.
The next financial statement we’ll be talking about is the Income Statement (sometimes referred to as a Profit & Loss or P&L for short). The Income Statement’s job is to show a company’s performance over a period of time (such as: For the Calendar year ended December thirty-first, two thousand and eighteen (12/31/2018) meaning January first, two thousand and eighteen (1/1/2018) through December thirty-first, two thousand and eighteen (12/31/2018)
In its simplest form the Income Statement can summarized as Revenue minus Expenses equals Net Income; or Income minus Expenses equals Net Income.
An Income Statement can have multiple tiers. For example QuickBooks P&Ls allow for three tiers:
Revenue minus Cost of Goods Sold equals Gross Profit
Gross Profit minus Expenses equals Net Ordinary Income
Other Income minus Other Expenses equals Net Other Income.
Finally you get your result, Net Income, by taking Net Ordinary Income minus Net Other Income.
Finally the Statement of Cash Flows. The Statement of Cash Flow’s job is to show where cash is going and where cash is coming form. The Statement of Cash Flows is often overlooked but provide a lot of insight, particularly when paired with an Accrual set of financial statements.
The Statement of Cash Flows is broken down into three categories:
Adjustments to Cash from Operations. In this category you’ll find things like A/R, A/P, Inventory, and most other things that relate to Operations.
Net Cash from Investing Activities. In this category you’ll find things like the purchase or sale of Fixed Assets, Another Business, or Securities
Finally the Net Cash from Financing Activities category will contain most cash going to or coming from Creditors, Investors, and Owners.
The Statement of Cash Flows bridges the gap between the Income Statement and Balance Sheet. It can provide a lot of insight, because sometimes a company can be really profitable but not good at generating cash and other times a company generates a lot of cash and doesn’t see that the cash flow is unsustainable!