Understanding Financial Statements - An Overview for Entreprenuers

Financial Statements are records that present your business’s financial activity in a clear and concise way. These records are used by a variety of people to review your business’s financial health. It is important for entrepreneurs to understand the different records that make up the financial statements and how they work. Properly used and understood, financial statements let you, the small business owner, understand and manage your own business more effectively, and help you present an accurate representation of the financial health of your business to important allies.

There are four documents that generally make up the financial statements of any business. They are:

The Income Statement (also called the Profit and Loss Statement or the “P&L”);

The Balance Sheet (more formally the Statement of Financial Position);

The Statement of Cash Flows; and

The Statement of Changes in Equity

Each of these tell the story of your business in a different way. Taken together, they should offer the whole picture.

The Income Statement is used to look at the business’s profitability. It measures and totals the business’s income from all sources, and then shows the business’s expenses. The final line of the Income Statement shows the business’s net profit (or loss) over the period measured. The Income Statement covers a specific time period: monthly, quarterly, year-to-date and annual statements are the most common. You can determine the period covered in the income statement’s title. An income statement entitled “for the month ended 3/31/2015” covers all income and expense incurred in the month of March. An income statement entitled “for the quarter ended 3/31/2015” covers all income and expense incurred from January 1 - March 31. 

The Income Statement does not include money that may move in and out of the business that are not income or expenses. For example, if your business borrows money from someone during the period covered, that will not be shown on the income statement, because the money you get from borrowing is not “income” - it is not taxable. Similarly, if your business paid some of the principal of a loan back during the period covered, it will not be shown, because the repayment of a loan is not an “expense” - it is not deductible (the interest you pay on that loan, however, is an expense and is shown). 

A final note about income statements is that they may be prepared on a “cash” basis or an “accrual” basis. Cash basis statements record items of income or expense as they are actually received or paid by the company. On a cash basis, you record income when you actually receive the money, and you record an expense when you actually write and send the check. Accrual statements record the items of income and expense when they are earned or incurred. On an accrual basis, you record income when it becomes owed to you (you complete the work and send the bill), and you record expense when you owe the money (you receive the goods or the service), regardless of when you pay.

The Balance Sheet is used to show a business’s assets, liabilities and equity at any given point in time. Balance sheets have a single date on them, and speak as of that day. Typically, one would present an Income Statement for a given period, along with a balance sheet for the last day of that period. An Income Statement “for the year ended 12/31/2014”, then, might be accompanied by a Balance Sheet dated 12/31/2014.

The Balance Sheet measures all of the business’s assets (cash, accounts receivable, inventory, equipment, property, etc.). Note that the balance sheet shows the depreciated value of those assets, and detailed balance sheets might even show the original basis (amount you paid, generally) of the item, and then show how much depreciation has been taken and show the net asset value (basis - depreciation). All of the values of all of the assets are the totaled as “Total Assets”. 

The Balance Sheet then measures liabilities (trade payables, the principal amount of debts or loans owed, taxes owed but not yet paid) and equity (the value of all shares in the company plus any retained earnings). The total of all liabilities and equity together must equal the total of assets. In other words, assets balances with liabilities plus equity. That is why it is called a “balance sheet”, it must balance. Any increase in a business’s assets, without a corresponding increase in a company’s liabilities, therefore increases the company’s equity.

The Income Statement and the Balance Sheet are the two most commonly asked for and provided Financial Statements in a small business setting. The other two Financial Statements, though, are important to understand and can be used by the business owner to help better understand the business, even where they are not being asked for by outsiders.

The Statement of Cash Flows covers much of the same information as the Profit and Loss Statement - it covers items of income and expense for a certain period of time. The Statement of Cash Flows has two important differences, however. First, the Statement of Cash Flows is always a cash-basis statement. It measure the actual movement of cash in and out of the company. If the Income Statement was prepared on an accrual basis, the Statement of Cash Flows becomes critical to understand the company’s actual cash position at any given time. For example, if your company is owed a lot of money it has not yet been paid, the Profit and Loss Statement (accrual basis) may show a healthy cash flow, when in fact the bank account is empty.

The Statement of Cash Flows will reveal the drought of cash and alert you to take action to get those bills collected, raise cash, or delay expense. The other important difference is that the Statement of Cash Flows includes movements of money that are not included on the Income Statement because they are not items of income or expense (receiving or paying loans, for example), and it does not include things items that are on the Income Statement that do not involve actual movements of money (like depreciation expenses). In that way, the Statement of Cash Flows is a more accurate measure of the movement of cash and your business’s cash position even when the Income Statement was prepared on a cash basis.

Finally, the Statement of Changes in Equity looks specifically at the ways in which the “Equity” portion of the balance sheet changed over any given period. The Statement of Changes in Equity looks, like the Income Statement, at a given period of time, and measure the change in that portion of the balance sheet over that period of time. Assume, for example, we had a balance sheet dated 1/1/2014, and another balance sheet dated 12/31/2014. Imagine also that the Equity portions of those two balance sheets (the Share Capital and the Retained Earnings) was different. Some change had occurred to the equity over the period. The Statement of Changes in Equity for the Year Ended 12/31/2014 would explain, in detail, the reasons for those changes. The Statement breaks the reasons for the changes down into categories (changes in accounting policy or corrections from a prior period, issuing or redemption of capital shares, income, etc.).

The Statement of Changes in Equity is most often used in a small business setting where there are non-managing investors who want an easy to review document that details what has happened with their investment, without having to wade through all the other Statements to figure that out.

Financial Statements can be used by business owners to better understand their business and its assets and cash flows and to make decisions. Financial Statements are used by the business’s professional advisers to make legal, business and tax/accounting recommendations. Financial Statements are used by investors to decide whether to invest in your business or to monitor their investment. Financial Statements are used by banks and other lenders to decide whether to make credit available to the business. The ability to understand and provide accurate financial statements can be critical for small business owners. In future posts, we will look at these important documents in more detail.