Understanding your Financial Statements

As a business owner, you have probably heard it a hundred times over: businesses fail due to poor cash flow management.

However, knowing the cash inflows and outflows of your business are just one area of understanding the economic performance of your company. As a business owner, it’s important to understand each of the three financial reports.

The basics of a financial report

Your financial statements allow you to assess the health of your business accurately.

Every company needs to have financial statements. These statements, or reports, are what allows you to see the financial condition of the business. After all, don’t you want to know if your business your business making money or losing it?

Each of these three financial statements represents just one element of a business’s financial health. That’s why it’s important to understand the purpose of each report and why they matter to your business.

The Balance Sheet

The balance sheet evaluates the financial performance of your business at a point in time, which is why many use the analogy of a snapshot when referring to this report.

Your balance sheet has three sections: assets (what you own), liabilities (what you owe), and owner’s equity (retained earnings and common stock). The accounting equation is a simple way to understand this:

total liabilities + owners’ equity = total assets

What matters is that your balance sheet is balanced. And if it’s not, you have a problem.

Income Statement

Has your business generated a profit or incurred a loss?

The income statement shows a business’s financial performance, measuring how much net profit or loss produced, over a period of time (typically one year). The income statement has two sections: revenues (sales) and expenses (employee salaries, rent, insurance, etc.).

The important thing to keep in mind is that generating a profit does not always mean your business has a positive cash flow or is successful. And vice versa; incurring a loss doesn’t mean your business has negative cash flow or is doomed to fail.

Cash Flow Statement

Where does your cash come from and where does it go?

It’s critical to know and understand how your business produces and spends its cash. The cash flow statement reports your business’s cash inflows and outflows over a period of time.

There are three categories of cash flows (regardless of whether they are inflows or outflows): cash flow from operating activities (sales receipts and payments made), cash flow from investing activities (cash spend on purchasing and/or selling property, stocks, equipment), and cash flow from financing activities (dividends paid out to shareholders, taking out or paying back a loan).

Often referred to as the lifeblood of a business, the cash flow statement may be the most important report out of the three financial statements.

What is the difference between the Income Statement and Cash Flow Statement?

Both the income statement and cash flow statement allow you to see the financial performance of your business over a period. What sets these financial statements apart?

One of the critical differences between these two statements is that the income statement is based on an accrual basis while the cash flow statement is based on, well, cash. Or more specifically: the timing of when an expense or income is recorded versus when you actually receive or spend the cash.

For example: say our team provides financial and accounting services to a new client in May, but that client doesn’t pay us until June. This sale is recorded onto May’s income statement, but because the cash isn’t received until June, this activity doesn’t show up on the cash flow statement until June.

Read more about cash vs accrual accounting here.

The process of creating and managing financial reports is not easy for most small and mid-size business owners. If you need assistance managing your financial statements to ensure the economic performance of your business, contact us today.