Understanding Financial Statements

Understanding financial statements is an extremely important business requirement for all entrepreneurs, regardless of what kind of business you are involved with.

NOT understanding financial statements has probably led to the demise of more businesses than anyone cares to admit.

I do want to point out that everything in this report has to do with small businesses—incorporated or not.

Understanding the financial statements of large publicly held companies is quite different and is not specifically addressed in this report.

If you have read the previous report, Small Business Financial Statements, you will recall that financial statements are composed of these three major components:

  1. Balance Sheet
  2. Profit and Loss Statement (P&L)
  3. Statement of Cash Flow

Actually, understanding financial statements is fairly simple and straightforward once you learn what is in each of the major sections of financial statements.

So, let’s look at each of these three parts in a little more detail. We will start with the Balance Sheet, and I have provided a Sample Balance Sheet for you to download and print so you can follow along as we describe each aspect of the Balance Sheet. Click here to download your copy.

1.Balance Sheet

To begin understanding financial statements, we will start with the Balance Sheet. A balance sheet is divided into three major sections; (1) Assets (the good stuff), (2) Liabilities (the not-so-good-stuff), and (3) Stockholders Equity (a record of all the money invested in your company—including all the profit your company has made).

The Assets section of your Balance Sheet is comprised of two major parts; “Current Assets” and “Fixed Assets.”

Current Assets are made up of Cash and those things intended to be turned into cash in the reasonably near future—usually the next 12 months.

Fixed Assets are property, plant, and equipment—those things not intended for sale and are used to produce or provide the thing(s) you are selling.

Now, for the other side of the Balance Sheet—Liabilities.

The Liabilities section of your balance sheet is split between “Current Liabilities” (the things that should be paid within the next 12 months), and “Long-term Liabilities,” which are items due and payable sometime beyond the next 12 months.

Current Liabilities and Long-term Liabilities are added together for “Total Liabilities.”

Keep referring to the Sample Balance Sheet to help you in understanding financial statements.

The third major section of your balance sheet is normally the Stockholders Equity section, and this is where understanding financial statements begins to get a little more complex.

This is where all your investment money is recorded. If you “loan” money to your business, it is shown in the Liabilities section, but if you “invest” money in your business, it is shown in the Stockholders Equity section.

In addition, the Stockholders Equity section maintains a running record of the money your business has made since startup, and this is called Retained Earnings.

In larger businesses, a report called Statement of Retained Earnings is provided and it goes into considerable detail about the money that ends up in the "Stockholders Equity" section as Retained Earnings.

For smaller businesses however, we can assume that the profit (or loss) for the period will simply be transferred over to the Stockholders Equity section as a bookkeeping entry called "Retained Earnings Current Year."

A special "Statement of Retained Earnings" is not required for most smaller businesses (your accountant may not agree).

The Stockholders Equity (investments) is added to Retained Earnings for a total Stockholders Equity and Retained Earnings number. This number, when added to the Total Liabilities number must equal the Total Assets number in order to have your Balance Sheet “balance” (see sample Balance Sheet).

2. Profit and Loss (P&L) Statement

Again, I would suggest you download the Sample Profit and Loss Statement pdf report and print off a copy, so you can follow along with this discussion. This will help considerably in understanding financial statements.

The P&L Statement is a record of the money your business received (Sales Revenue) during a specified period of time; the money your business spent (Expenses) during the same period; and the amount of profit (or loss) earned during the same period (revenue minus expenses).

This document can be quite simple for the smaller business…or extremely complex for big corporations. However, the basic concept and general format are always the same.

Unlike the Balance Sheet, a P&L Statement has more latitude on how it is formatted. Much depends on the type of business you have, and how complex your bookkeeping system is—and how your accountant sets it up.

For some industries, standard formats have been developed. This helps to accurately compare your business to your industry standard and helps in understanding financial statements in your industry.

But more importantly, you need to have a format that helps you analyze your business.

However, all P&L Statements, regardless of detail, have major segments in common, such as:

  • Sales. This is usually the money you receive for selling your product(s) or service(s), minus any returns or allowances. This provides a Net Sales figure.

  • Cost of Sales. This is what you paid to acquire or produce your product(s) or service(s). If you are a one-person professional service, you may, or may not have an actual cost of sales.

  • Gross Profit. This is simply Net Sales minus Cost of Sales. This is the profit your business makes before any of the overhead costs are figured in.

  • Operating Expense. This is generally referred to as “overhead,” and includes all the other expenses you incur in running your business, such as: non-production or sales wages, rent, utilities, communications, office supplies, etc.

  • Operating Profit—EBITDA. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. True Operating Profit ( or EBITDA) is calculated by subtracting Operating Expense (excluding interest, taxes, depreciation, and amortization) from Gross Profit.

  • Other Income (Expense). You do have to account for all income and expense for your business, so this is where you would have non-operational items, such as: income from bank accounts, tax refunds, miscellaneous income, etc. as well as expenses, such as: interest, depreciation, amortization, and the like.

  • Pre-tax Profit. This is simply the total taxable profit your business made before paying income taxes, and is calculated by subtracting "Total Other Income (Expense)" from your EBITDA Operating Profit.

  • Income Tax Allowance. This is the total tax (including state income tax) you will be expected to pay on the profits from your business. Since most tax returns are prepared differently than P&L Statements are, the number here may not compare exactly (sometimes not at all) with the tax number being shown on your tax returns. Understanding financial statements does not mean you will understand tax returns—I rely on a good accountant for that.

  • Net Profit. This is the number that is usually referred to as “the bottom line,” and normally the one you want to be as large as possible.

For owners of small businesses it is better to work with an expanded P&L that shows much more detail than a typical "accountants" P&L.

With an expanded P&L you can make your own analysis of performance, determine the trends of certain line items, and if anything looks out of the ordinary, or questionable, you can request an “account analysis” from your bookkeeper.

This will tell you the details of what all went into that specific account (line item) on the P&L. Expanded, or "detailed" P&L Statements will help you considerably in understanding financial statements.

When presenting your P&L to outsiders (banks, vendors, investors, etc.) you can collapse the format and eliminate much of the detail.

3. Statement of Cash Flow

This is the 3rd and final segment of your set of Financial Statements. This document is prepared by your accountants, and is an integral part of your year-end financial statements. This document tells you where your cash from last year was spent.

The Cash Flow Statement is too late to be of much current value, but, it can be used for comparing your cash flows from year to year.

It is sometimes an important document when discussing your business with bankers, stockholders, Venture Capitalists, and potential buyers of your business.

If you want a more indepth understanding of your financial statements, you may want to take a look at my book, Small Business Financial Statements: What They Are, How to Understand Them, and How to Use Them. For more information--click here.

Understanding financial statements requires getting used to a few different terms used by accountants, for instance: some of the terms used in this report might be different than the terms your accountant will use, such as: retained earnings are often called accumulated earnings, or as it was called in the past, earned surplus.

Other terms may crop up along the way, but they are usually self-explanatory, or ask your accountant to explain them to you.

But the concepts remain the same: there is a “Balance Sheet”, a “Profit and Loss (P&L) statement”, and a “Statement of Cash Flow.”

These items are the backbone of your financial statements (regardless of how your accountant names them) and everything else is merely a detail.

After you have absorbed this report on Understanding Financial Statements, the next report that should be of interest is Financial Statement Analysis.

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