Reading and Interpreting Financial Statements
The income statement, balance sheet and cash flow statements are three important tools that you can use to analyze your small business, and provide financial information for banks and potential investors. This article will explain the benefits of analyzing each financial statement, and provide examples of how these statements are all connected. Our other article, Ratio Analysis, provides a more in-depth look at how you can use common financial ratios to derive more information about your business’ performance.
An income statement, also known as a profit and loss statement, provides an overview of a company’s revenue and expenses during a specific period. The income statement is one of the most common financial statements that businesses use to analyze their financial health. Income statements provide important information about your business including revenue, cost of goods sold, selling/general/administrative expenses, interest expenses, income taxes, and the company’s net income.
The income statement provides information about the performance of a business over a specific timeframe, usually a year, rather than at a specific point in time. Small business owners can easily prepare their own income statements, and compare them to previous years or quarters, to see how their business has been performing.
Single-step vs. multi-step Income Statement: There are two common types of income statements, which include single-step and multi-step income statements. While both of these statements calculate revenue and expenses, the multi-step is more detailed, as it follows a three-step process to calculate net income.
Multi-Step Income Statement
#1 Gross profit= Net revenue- cost of goods sold
#2 Operating Income= Gross Profit- operating expenses
#3 Net Income= Operating income+ non-operating income
Below are some of the main components of an income statement:
- Revenue: Revenue, also referred to as sales, shows how much money a company made from selling its product or service. Revenue is listed at the top line of the income statement.
- COGS: Cost of goods sold includes all of the costs associated with producing a product, including costs like manufacturing, design, and shipping.
- Gross Profit: Gross profit is defined as the revenue minus the COGS, and is used to show how much money a company makes from selling a product after it has paid for the cost of producing the product.
- Operating expenses: Operating expenses are some of the costs associated with running and operating a business, including hiring employees, renting office spaces, and other expenses. These expenses are located below the gross profit on the income statement, and above the company’s operating income ( revenue-operating expenses).
- Interest expenses: This section of the income statement shows how much the company is paying in interest expenses on its debt.
- Income taxes: This section is located right below the net income section of the income statement, and shows how much money the company pays in taxes.
- Net income: Net income, or the bottom line, shows if the company is profitable. This amount includes the company’s revenue minus all of the expenses, interest, and taxes that it pays when operating.
Analyzing an income statement can help you answer important questions about your business such as:
- How much money are you making?
- Are you profitable?
- What are you spending money on and how has this changed compared to previous years?
- Is your business growing?
- How has your business taken advantage of depreciation to lower its income taxes?
However, solely focusing on the income statement has many types of limits, and misses key issues addressed in other statements.
Cash flow issues: A business can be unprofitable and still have sufficient cash flow, and a profitable business could still run into cash flow issues in some cases. This occurs because of a concept called accrual accounting, which states that revenue and expenses are recorded when a transaction is made, rather than when a payment is received.
Example: A business received a large sale from a new client in December 2022 who plans to pay the company back in 180 days. This transaction would be reported as revenue in the company’s 2022 financial statements, even though they will not receive the cash for this payment until 2023.
Another important issue to consider when looking at your income statement is depreciation, as some companies’ net income may be lower just because they rapidly depreciate an asset during the first year. Although it makes sense from an accounting perspective to depreciate an asset as quickly as possible because of the tax benefits, it can result in the company’s profitability looking worse than it actually is, even when its cash flow is fine.
Finally, small business owners should be aware that not all aspects of the income statement are set in stone, and conditions can change. In some cases, amended tax returns can change the situation of the small business, and cause it to overstate or understate its net income.
Example: A small business owner files taxes and prepares an income statement based on the taxes that it projects that it owes to the IRS. In reality, the IRS calculated that the small business owner owes more money in taxes, and also has to pay a penalty for the previous year. In this case, the company’s net income would actually be lower than initially stated in its income statement.
Another part of the income statement to closely follow is the cost of goods sold. First of all, there are many different types of ways to calculate the cost of inventory, such as FIFO ( first in first out), LIFO ( last in first out), and the average inventory method.
Example: If a company purchased 50 materials for $100/unit and then 50 materials for $130/unit one month later, they can report the cost of goods sold in many different ways. For example, the company could use FIFO and report the cost at $100/unit, LIFO and report it at $130/unit, or the average inventory method and report it at $115/unit. The accounting method the company uses could have a significant impact on the company’s income statement. A company may prefer to use LIFO in this case, if they want to immediately lower their income taxes.
The balance sheet is another useful financial statement that is used to provide an overview of your company’s financial position at a specific point in time. This statement can be used for a variety of purposes, including calculating the value of your company, analyzing the amount of debt you have, analyzing your assets, and calculating your liquidity. Balance sheets are prepared in regular intervals, such as annually or quarterly, and show a company’s financial position at that point in time.
Businesses often look at the common formula when preparing a balance sheet.
Assets = Liabilities + Equity
This statement can also be rearranged in other ways.
Equity= Assets- Liabilities
Companies can prepare these statements individually at any chosen point in time, and ensure that the equation balances when they finish it.
Types of Assets
An asset is any type of resource, whether it be tangible or intangible, that adds economic value to the business. Assets represent any type of property that a company owns that can eventually be converted into cash. There are also additional ways to classify assets such as convertibility or tangibility. Convertibility describes how easy it is for an asset to be converted to cash. For example, some assets may take 3-6 months to sell and would be considered less liquid than other assets, like an investment in a money market account for example. Tangible assets are also classified based on their physical usage.
Below are some examples of common assets that business owners would include on their balance sheet:
- Cash and cash equivalents:
- Accounts Receivable
- Office equipment
- Short-term investments
Not all business assets can be converted to cash because they differ in liquidity, and some of them are vital to the company’s operations, so the owner does not ever sell them.
Current assets: Current assets are defined as assets that can be easily converted into cash and cash equivalents. To qualify as a current asset, the asset should be able to be converted into cash within a year or less. Some examples of current assets include cash, cash equivalents, and accounts receivable.
Non-current assets: Non-current assets, also called long-term assets, are assets that the business uses to generate income, and they typically can’t be sold quickly. Some common examples of non-current assets include long-term investments, property, plant and equipment, and other types of intangible assets, like copyrights.
Tangible vs. Intangible
Tangible: A tangible asset is a type of asset that has a physical substance, and includes common assets like equipment, inventory, land, and machinery.
Intangible: Examples of common intangible assets include computer software, trademarks, patents, films, and copyrights.
Operating vs. Non-Operating
Operating: Operating assets are assets used to help the company generate revenue. Examples of operating assets include inventory, machinery, equipment, and patents.
Non-operating: These assets are listed on a company’s balance sheet, but are not used by the company to generate revenue. Examples of non-operating assets include vacant land, idle equipment, recreational equipment, and loans receivable.
Liabilities include any amount of money that a business owes to someone else, including a vendor, bank, or another business. There are three main types of liabilities, which include current liabilities, non-current liabilities, and contingent liabilities. Liabilities are a normal part of operating a business, and they can fluctuate over time, so it is important to constantly track them and do everything you can to lower your liabilities as a business owner.
Some common types of liabilities that you may have already heard of include the following:
- Accounts Payable
- Deferred revenue
- Accrued expenses
- Income tax payable
Current Liabilities: Current liabilities, which are more commonly known as short-term liabilities, include liabilities that you need to pay completely within one year. Issues with current liabilities are very important to monitor, as they can create liquidity issues for businesses that are unable to pay these liabilities. Common types of liabilities include accounts payable, income taxes payable, and short-term loans.
Non-current liabilities: Non-current liabilities, also known as long-term liabilities, are liabilities that a company has to pay, but the company can pay them over one year from the current date. One of the most common examples of non-current liabilities include loans that small businesses have to purchase machinery or other equipment to finance their business growth. Another common example includes long-term capital leases, as these are usually signed for longer terms.
Contingent Liabilities: Contingent liabilities are a bit more complicated to analyze, as these are liabilities that may or may not occur. If your company has a pending lawsuit, then this would be listed as a contingent liability until the business knows if and how much it has to pay.
While examining your balance sheet can help identify some key issues, especially if you look at key liquidity issues, there are some limitations to solely relying on a balance sheet analysis.
Example: Although looking at your accounts payable amount on the balance sheet may help, it most often does not include information like overdue balances and the number of days overdue. In this case, adding footnotes or internal notes could be more helpful, and provide a full picture of the health of your business.
Benefits of understanding your balance sheet
It can be very useful for you to analyze your balance sheet and have this information prepared already. If you plan to apply for a loan or raise money from an investor, one of the first things they will ask for is a company balance sheet to analyze. A lot of key financial information is in the balance sheet.
You can calculate your total debt and determine how this debt compares to previous periods. This information can be useful if you are deciding to pay off a loan early or apply for another loan.
You can also compare other parts of your balance sheet, such as your assets, to previous periods to see how your financial health is improving.
Moreover, small businesses can focus on short-term liabilities, in combination with other liquidity ratios, to ensure that they do not have any solvency issues. There are many liquidity ratios that you can use to determine what challenges your business may have in paying short-term liabilities.
Other investors may want to analyze the equity section of your balance sheet if they want to invest in your business. Moreover, if you apply for a loan from a bank, they will definitely need to see your balance sheet and other supporting information, such as lien positions for certain assets, for example.
Example: A bank may be hesitant to offer you a loan if you already received a loan from one or more banks, who already have a first or second lien position on your assets. In this case, you may need to use different collateral, if applicable.
Moreover, some analysts may compare key financial ratios from your balance sheets to peers when deciding to invest in your business or offer you a loan.
Cash Flow Statement
The cash flow statement is arguably one of the most relevant statements for small business owners. While the income statement provides an overview of revenue and expenses, cash flow statements help determine if the company can adequately make payments and secure funds for future expenses. Issues that are not present in the income statement can be present in the cash flow statement, so it is important for small business owners to take a close look at both. There are three different types of sections on the cash flow statement, which relate to cash from operating, investing, and financing activities.
Operating: Cash flow from operations focuses on any cash that a business receives from its traditional operations, and includes revenue and expenses.
Investing: Cash flow from investing includes any cash spent on purchasing or selling any assets using cash obtained from the business, rather than debt.
Financing: Cash flow from financing focuses on money used to secure loans and to pay off these loans.
Cash flow for a quarter or period can be negative or positive, depending on how a business performs. Although a cash flow statement has some similarities to an income statement, it is crucial to note that a cash flow statement does not indicate profitability. A company that has a positive operating cash flow, may not be profitable for many reasons.
Moreover, cash flow does not tell you a company’s position at a specific point in time or the company’s profitability. A cash flow statement is similar to an income statement, in the sense that it measures the performance of the company over a specific time period, like an entire year or quarter.
You can make adjustments to your net income to arrive at the figure for operating cash flow. You can do this by removing items like depreciation and deferred income tax. Rapid depreciation is one common reason why a company with positive operating cash flow could still report a net loss.
Example: A company’s cash flow from operations was $10 million in 2022. However, the company was able to recognize over $20 million in deprecation during the year. Therefore, the company will report a net loss in 2022, even though it had positive operating cash flow.
Moreover, it is also important to understand how certain balance sheet activities can impact your company’s cash flow.
Example: Your company had stellar financial results during December 2022 due to increased revenue from a new client. However, the client plans to pay for these products over the next six months. Although you can immediately report this on your 2022 income statement and taxes, these activities will impact your cash flow statement in 2023.
Understanding all three financial statements is very important for small business owners, as it can help them analyze their business, and also help them to secure a loan or raise money from an investor. It is important to understand the differences between each statement, and the limitations of solely relying on one type of financial statement. Most importantly, it is crucial to understand how all three financial statements interact with each other to fully understand your financial situation.
Categorised in: Planning, Startups
This post was written by Sean Allaband