The Beginner's Guide to Financial Statements

inancial statements provide a comprehensive view of your business's financial health, which can be used to make informed decisions about operations, investments, and growth strategies. Financial statements can help you understand business performance, make better decisions, attract investors, and comply with legal regulations.

The three major categories of financial statements are income statements, balance sheets, and cash flow statements. Understanding how to create, analyze, and act upon these reports is essential to seeing your business flourish.

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Understanding Income Statements

Also called a profit and loss statement, an income statement provides a summary of the company’s revenues, costs, and expenses over a specific period of time. It shows the net profit or loss made by the business. It provides information about your company's ability to generate profit by increasing revenue, reducing costs, or both.

An income statement typically includes the following main components:

• Revenue/sales: This is the income generated from the sale of goods or services before deducting any costs or expenses. It's often listed at the top of the income statement.
• Cost of goods sold (COGS): This includes direct costs associated with producing goods or services your company sells. It might consist of material costs, direct labor costs, and direct factory overheads, as applicable.
• Gross profit: Calculated as Sales minus COGS, gross profit shows the profit your company makes after deducting the costs directly related to producing your goods or services.
• Operating expenses: These are the costs not directly tied to producing goods or services. They include administrative and sales expenses, depreciation, and salaries.
• Operating income: Calculated as Gross Profit minus Operating Expenses, operating income reflects the profit from regular business operations, disregarding interest and taxes.
• Interest and taxes: Interest expenses and taxes the company paid are calculated and listed.
• Net Income: Your company's total earnings or profit, calculated as Operating Income minus Interest minus Taxes. It's often called "the bottom line" because of its placement at the bottom of the income statement.

Let's say a hypothetical company, Acme Corp, had revenue of $500,000. Their COGS was $200,000, providing a gross profit of $300,000 ($500,000 revenue - $200,000 COGS). After accounting for operating expenses of $100,000, the operating income becomes $200,000. Subsequently, deducting interest of $20,000 and taxes of $50,000, Acme’s net income or profit stands at $130,000.

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Decoding balance sheets

Balance sheets provide a snapshot of your company’s financial condition at a specific point in time. It lists all of your assets, liabilities, and shareholders' equity, showing the net worth of the business.

Structure of a balance sheet

The balance sheet is structured according to the fundamental accounting equation:

Assets = Liabilities + Owner's Equity

It's essential for this equation to remain balanced. It's also the basis for double-entry bookkeeping. The balance sheet typically gets divided into two parts that, per the equation, must equal or balance each other out at all times.

Assets

Assets are resources owned by your company. They're measured in monetary terms and have future economic value. They are often divided into the following categories:

• Current assets: These are assets you expect to convert into cash within one year, including cash, accounts receivable, and inventory.
• Non-current assets: These include long-term investments, property, plant, and equipment, and intangible assets such as patents and trademarks.

Liabilities

Liabilities represent the company's obligations or what it owes to others. They are also divided into two categories:

• Current liabilities: These are obligations due to be paid within one year, including accounts payable, short-term loans, and salaries payable.
• Non-current liabilities: These are long-term debts or obligations due to be paid after one year, including long-term loans, lease obligations, and bonds payable.

Owner's equity

Also known as shareholders' equity for corporations or retained earnings, owner's equity represents the amount of money returned to a company's shareholders if you were to liquidate all your assets and pay off your company's debts.

Here’s a simplified example of a balance sheet:

Suppose Acme Corp has total assets of $1,000,000. Current assets are $600,000, which includes cash, accounts receivable, and inventory, while non-current assets, like property, plant, and equipment, make up the remaining $400,000.

On the liabilities side, Acme Corp has current liabilities of $200,000 and non-current liabilities of $300,000. Hence, the Owner's Equity or shareholder's equity is $500,000 ($1,000,000 Total Assets - $200,000 Current Liabilities - $300,000 Non-current Liabilities).

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Interpreting cash flow statements

A cash flow statement is one of the primary financial statements used by businesses. It shows how changes in balance sheet accounts and income affect cash and cash equivalents, and it breaks the analysis down according to operating, investing, and financing activities. Essentially, the cash flow statement concerns how money moves in and out of your business and whether it does so in a sustainable fashion.

Cash flow statements provide detailed information about your company's cash receipts and cash payments during a given period. They give insight into information about a company's liquidity, solvency, and ability to change cash flows in future circumstances. Use your business’s cash flow statement to analyze its financial viability.

The cash flow statement typically includes the following sections:

• Cash flow from operating activities: This section includes cash flows that directly result from your daily core business operations, such as selling goods or services to customers. These activities might consist of cash received from customers, cash paid to suppliers, wages paid to employees, interest paid/received, and taxes paid.
• Cash flow from investing activities: This section reports cash flow from acquiring and disposing of long-term assets and investments. Examples include purchasing or selling property, plant, and equipment (PPE), investments in securities, and acquisitions of other businesses.
• Cash flow from financing activities: This section shows cash flows from and to external sources, such as lenders, investors, and shareholders. Examples include proceeds from issuing equity or debt, repayments of debt, and dividends paid to shareholders.
• Net increase or decrease in cash and cash equivalents: This section shows the net change in your company's cash position over the reported period. It's calculated as the sum of cash flows from operating, investing, and financing activities.

As an example: In one financial year, Acme Corp generated $250,000 cash from operating activities (like selling products), invested $100,000 in long-term assets (like machinery), and raised $50,000 from a new loan while repaying a previous loan of $30,000. So, the net increase in cash would be $170,000 ($250,000 from operations - $100,000 investments + $50,000 from financing - $30,000 repayment).

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Importance of financial ratios

Financial ratios allow business owners to perform essential analytical tasks, including:

• Evaluating business performance: Financial ratios help you assess the performance of your business across various aspects such as profitability, liquidity, efficiency, and leverage.
• Identifying trends: Financial ratios can help identify trends in business performance, revealing areas of strength and weakness.
• Benchmarking performance: These allow your business to compare its performance to industry standards and competitors, providing valuable context.
• Making informed decisions: By providing insights into financial performance, ratios can inform strategic decisions about growth, investment, and operational efficiency.

Business owners should understand a few key financial ratios:

• Current ratio (liquidity ratio): Current Assets divided by Current Liabilities. This ratio indicates the ability of a business to pay its short-term obligations. A ratio above one indicates that the business can comfortably meet its short-term liabilities.
• Quick ratio (acid-test ratio): (Current Assets minus Inventory) divided by Current Liabilities. This ratio is a stricter measure of liquidity as it excludes inventory, which may not be possible to convert quickly to cash.
• Debt-to-equity ratio (leverage ratio): Total Debt divided by Total Equity. This ratio shows a company's financing balance between debt and equity. A higher ratio indicates higher financial risk but also potentially higher returns.
• Gross profit margin: Gross Profit divided by Total Revenue. This ratio measures profitability after accounting for the cost of goods sold. A higher gross profit margin is generally better.
• Net profit margin: Net Income divided by Total Revenue. This ratio measures the overall profitability of a business. A higher net profit margin indicates that a business is more profitable.
• Return on assets (ROA): Net Income divided by Total Assets. This ratio measures how effectively a company uses its assets to generate profit.
• Inventory turnover: Cost of Goods Sold divided by Average Inventory. This ratio measures how quickly a company can sell its inventory. A higher turnover rate typically indicates better performance.

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Final thoughts

Financial statements are vital in shaping your business's financial health and strategy. They provide insights into your company's performance and financial position, which is essential for decision-making, strategic planning, and attracting potential investors.

As a small business owner, understanding and regularly reviewing these financial statements and ratios will help you assess the current state of your business and inform strategic decisions that drive future growth and success. Novo's business banking can help you stay on top of your company's financial health by allowing you to track your income and expenses easily.

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