Understanding Financial Statements

1. Balance Sheet
2. Profit and Loss Statement (P&L)
3. Retained Earnings Statement
4. Statement of Cash Flows

So, let’s look at each of these four parts in a little more detail. I suggest you open up the Sample Balance Sheet pdf report (opens in new window) and compare the samples shown there with the following descriptions:

1.Balance Sheet

Your small business balance sheet is further 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 composed of “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.

Here are some of the items that could appear in the Assets section of your Balance Sheet:

Current Assets
• Cash in the bank
• Inventory (raw materials and finished products)
• Accounts Receivable (money owed to your company)
• Prepaid Expenses (rent, insurance premiums, etc., paid in advance)
Fixed Assets
• Property (any Real Estate your company owns, or is buying)
• Equipment (any equipment your company owns, or is buying)
• Vehicles (any vehicles your company owns, or is buying)
Total Assets
• The sum of current assets plus fixed assets

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

Here are the kinds of things that could appear in the Liabilities section of your Balance Sheet:

Current Liabilities

• Accounts Payable (bills you owe)
• Short-term Loans (equipment loans, leases, etc.)
• Revolving lines of credit (accounts receivable loans, etc.)
• Current portion of long-term debt (amount to be paid over the next 12 months)
• Any unpaid expenses owed by your company that is due within the next 12 months)
Long-term Liabilities

• Long-term debt (beyond the next 12 months)
• Notes payable to stockholders (when stockholders loan money to your company)
• Any debt payable beyond the 12 months included in Current Liabilities
Total Liabilities

• The sum of Current Liabilities plus Long-term Liabilities

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 the 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.”

After you begin understanding financial statements better, you will see that, the Balance Sheet is a record, or “tally” of the worth of your business—according to your accounting records. You have "Assets" (what your company owns, or is owed), "Liabilities" (everything your company owes), and "Equity" (everything the owners or stockholders have invested in your company, plus profits to date). The Balance Sheet is actually the most important accounting document for your company.

2. Profit and Loss (P&L) Statement

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.

Again, I would suggest you open up the Sample Profit and Loss Statement pdf report (opens in new window) so you can follow along with this discussion. This will help considerably in understanding financial statements.

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

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. This section of the P&L can also get a little more complex if you have a manufacturing business and want to show inventories, purchases, and production labor in this section of the P&L.

  The objective here is to arrive at a true cost of sales and at the same time track inventory levels, purchases, and production labor trends against sales. Although this is a common practice, it is not necessary for any business that does not carry an inventory of parts and/or products.



• 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.


• Selling Expense. This is the expense incurred for selling whatever you are selling. It could be the cost of maintaining a sales staff, paying commissions, advertising, P.R., other forms of marketing, and any cost associated with the process of selling.

  Some accountants will want to put this cost in as part of the Cost of Sales; some will put it as a separate standalone section below the Gross Profit line, and others will include it in with the General Operating Expenses. Much depends on your accountant, your bookkeeping system, and the type of business you have—plus your own personal preference.



• Operating Expense. This is generally referred to as “overhead,” and includes all the other expenses you incur in running your business, such as: wages, rent, utilities, communications, office supplies, etc. I prefer not to include depreciation, amortization, or interest in this section because they are more “strategic” expenses than day-to-day cost of running your business. This, of course, may disturb your accountant greatly because they like to show all "operating" expenses together. Accounts have a difficult time understanding financial statements from a CEO's point of view.

  Note: When accountants prepare their annual report, they will usually collapse these detailed line items of expense and show them as simply Selling, General and Administrative, or S,G & A expenses. They may then show the details in the “Notes” section of their report. The sample P&L Statement shows an "expanded" report to better help in understanding financial statements.



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

  This is a true measure of how your business operated during the specified period, because the numbers are not skewed by non-operating expenses such as: interest, taxes, depreciation, and amortization.

  EBITDA is a number you and your bookkeeper will have to work on, because your accounting firm (if you have one) will likely pitch a fit when you ask them to do it. EBITDA is more of an “operational” approach to your P&L, and less of an “accounting” approach.



• Other Income (Expense). You do have to account for all income and expense for your business, so this is where you would put 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. At least this is where I put all non-operational items even though most accountants disagree.


• 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 with the tax number being shown on your tax returns.


• 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.

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 that likely would not mean much to those people anyway.

3. Retained Earnings Statement

Although this is considered a separate document by accountants, it is only useful as your business grows substantially. In normal practice, this information is included in the Stockholders Equity section of your Balance Sheet, and is placed there by a bookkeeping entry.

For the smaller business, a separate document is not necessary, and if you understand about Retained Earnings and Stockholder’s Equity, as they affect your Balance Sheet, then you can ignore this document for now. This will make understanding financial statements much easier. (Your accountant may tell you differently.)

4. Statement of Cash Flow.

This is the 4th 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, but like your Balance Sheet, it is only viable for one day because the information changes daily. However, it can be valuable for comparing your cash flows from year to year.

It is also an important document when discussing your business with bankers, stockholders, Venture Capitalists, and potential buyers of your business. Accountants love it, but remember, they must follow a prescribed set of “accounting” standards (GAAP) that may, or may not, help you run your business.

For daily operating information, there are better ways to monitor your cash, so don’t get too hung up on this document unless it is requested by outside sources. In fact, in my opinion, this document can be ignored all together—until your business becomes large enough that this document becomes important to investors or buyers.

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