Financial statements are the reports summarizing important financial information for your business. Financial statements act as a control panel that allows business owners to see where the money is coming from, where it is going, and how much money the business has to work with. Statements are typically composed of three specific types of reports. Those three documents are the balance sheet, the income statement, and the cash flow statement. These three reports combine to give both the business owner and outside people like investors or lenders a comprehensive picture of the business’s financial position.
Up-to-date and properly prepared financial statements are an important tool for business owners to use. Not only can financial statements highlight ways to optimize your company’s financial success, but they are also used to help secure loans by proving your business is profitable and sustainable. Apart from securing loans, accurate financial statements are also important for helping you manage your business and prepare taxes.
#1 Balance Sheet
1. What Is A Balance Sheet?
A balance sheet is one of the three cornerstones that comprise a business’s financial statements. In a simplistic definition, it is your company’s assets on one side and your company’s liabilities and equity on the other. Your balance sheet will show what assets your company has and what liabilities offset that at a particular point in time. In other words, a balance sheet illustrates what your business’s finances are currently.
2. How To Create A Balance Sheet
The balance sheet formula can be simplified to assets – liability = equity. When creating a simple balance sheet, you’ll typically want to include all of the business’s assets sorted by liquidity, covering all current and long-term assets. Current assets include things like:
- Cash
- Cash equivalents
- Receivables
- Fixtures
- Inventory
- Prepaid expenses
Long-term assets are assets that would take over a year to be converted into cash and include things like:
- Property
- Equipment
- Long-term securities
- Intangible assets like copyrights or patents.
After listing your assets, you will list your company’s liabilities. Liabilities are all of the money that your business owes. Similar to Assets, liabilities can be categorized into short and long-term. The short-term liabilities are what your business owes in the next year such as Accounts Payable, short-term loans, and the current portions of long-term loans. In comparison, long-term liabilities are those that will not be satisfied in the next year like deferred income taxes and long-term loans. This balance sheet format is fairly simple and is typically used by third parties like lenders to determine the financial strength of the business. Balance sheets will also be used in some cases for tax purposes because they list any depreciating assets.
3. Common Mistakes/Issues
It is a common mistake for business owners to overlook the balance sheet when considering their financial statements because they feel like the balance sheet isn’t telling them what they think they want to know about the company outside of what the cash position is or the expected cash position based on receivables and payables. Another mistake, which is the biggest mistake often seen on a balance sheet, is accounts with negative values. What that means is that the transactions that are affecting those accounts are not being handled correctly. Another common mistake that business owners make when filling out a balance sheet is that they misclassify long-term assets and liabilities as short-term.
4. You should Be Looking At A/R & A/P Daily, Everything Else You Can Look At Monthly
Senior management should be using the balance sheet as a regular tool to help them guide their businesses. Accounts receivable and accounts payable are two areas that business owners should review and understand almost daily. For the rest of the balance sheet, owners should review whenever you are generating financial statements; typically monthly.
5. Gauging The Financial Health Of A Business
Despite being often overlooked compared to other financial statement documents, a balance sheet shows the overall financial health of a company. If a business is financially healthy, it will have a good-looking balance sheet.
#2 Income Statement
1. What Is An Income Statement?
An income statement is a financial statement that shows a company’s income and expenses. The income statement formula is: Revenue – Cost of Goods Sold (Direct Expenses) = Gross Profit. Then, Fixed Expenses and Other Expenses (such as depreciation and taxes) come out of this gross profit number which leaves you with how much the business is making.
2. How To Create An Income Statement
To create an income statement, you need to pay attention to a few nuances of the income statement. It is important to break down your revenue and revenue sources and understand when you are seeing revenue from those different sources. Your revenue will be your top line of the income statement. Once you have totaled your revenue, you subtract your cost of goods sold to find your gross margin. From your gross margin, subtract your selling, general, and administrative expenses. This leaves you with your EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization. Lastly, your interest and your depreciation and amortization line items are deducted to find your pre-tax income. After finding your pre-tax income, you can calculate your net income by subtracting your income tax line item from the pre-tax income. Net income should be the very bottom line of this income statement format.
3. Common Mistakes/Issues
There are several common mistakes, issues, and red flags to look out for when creating an income statement. One of the most common is misrepresenting expenses. Where income statements can get tricky is the assigning of direct expense or cost of goods sold. These are the expenses that are directly related to the revenue that you generate. Your direct cost is going to fluctuate with your revenue as it is the cost of generating that revenue. Generally, the greatest issue found on an income statement is determining between fixed costs and direct expenses. It is important to capture all of the costs that are associated with generating revenue without mixing in any fixed costs because you will need an accurate number to calculate your gross margin, and managing that gross margin is critical to managing your business.
4. Advice To Having A Really Good Income Statement.
Understanding the concept of EBITDA is important when structuring your income statement. What is EBITDA? It is an acronym for earnings before interest, taxes, depreciation, and amortization. Where gross margin provides real-time, day-to-day data, EBITDA is a calculation used when you produce your financial statements. When people are looking at financial statements to judge whether or not a company is being run successfully, they look at the EBITDA number. Business owners can structure their financial statements to give them a good EBITDA number. Putting things like depreciation, interest income, and tax payments below your net profit line when you prepare an income statement is a good, common practice in general.
Financials For Taxes vs Lenders
1. How Lenders Use Financial Statements
Lenders rely on financial statements to provide accurate and easily comprehensible data that is used to determine the financial health of the business. Financial statement analysis for lenders allows them to assess the solvency and observe the profitability and value of a business. Lenders assess this information and look for two things. The first thing lenders look for are things that they can collateralize, and the second is the ability of the company to repay whatever is lent to them. Different lenders will have different standards that they use. However, these standards are used to determine in their eyes the financial health of the company.
2. How Financials are Used for Taxes
First, let this be a disclaimer that this is not tax advice but rather a general description to help further the understanding of how these financial statements can be used for tax purposes. As a general rule, if your company is paying corporate income taxes, you’ll need to know how much the company is making, so having up-to-date financial information is helpful for this. One thing to realize is that the financial statements that you use to run the company may not be the financial statements you use for filing taxes. There may be some changes that your tax CPA makes to make it more advantageous for the business.
#3 Cash Flow Statement
1. What Is Cash Flow?
Cash flow is the timing between the cash that your company is bringing in versus the cash that is going out. You always want to have as close as possible positive or neutral cash flow within your business. Generating a cash flow statement, also known as a statement of cash flows, is a standard way to show how much cash a company receives and then spends on operating, investing, and financing activities. Analyzing a cash flow statement can give you a better understanding of your company’s liquidity, flexibility, and overall financial performance.
2. How Is Cash Flow Tracked?
Effectively managing and tracking cash flow goes beyond just the cash flow statement and involves understanding the nature of the transitions that are running through your business and understanding when cash comes in and when cash goes out and what can be done to minimize that spread. You can track this in a variety of different ways using a variety of different models suited specifically for your business.
3. How to Prepare a Cash Flow Statement
Formal cash flow statements are not always commonly requested and typically third parties don’t look for them. However, it is still important to understand how to create a cash flow statement. Cash flow can be represented on a cash flow statement through two different formats. The two formats are indirect and direct. With an indirect format, your cash flow statement starts with the net income from your income statement, and then you make adjustments for depreciation, accounts receivable, inventory, accounts payable, and accrued expenses to arrive at your cash flow from operating activities. A direct format lists all of the different types of cash amounts received from customers as well as those paid to employees and vendors.
Conclusion
Financial statements are important tools required for a business to be successful. They are the reports summarizing your business’s important financial information. They indicate where the business’s money is coming from, where it is going, and how much money the business has to work with. “Financial statements” is an all-encompassing term that refers to primarily three separate financial documents. The first is a balance sheet. A balance sheet is a report that summarizes a company’s assets and liabilities. In other words, a balance sheet illustrates what a business’s finances are at a current, particular moment in time. The next financial statement is an income statement. An income statement shows a company’s income and expenses. This document will not only show what a company’s bottom line is but also its EBITDA number which is used to determine how successfully a company is being run. The final document is the Cash Flow Statement. Cash flow is the timing between the cash that your company is bringing in versus the cash that is going out and showcases a company’s liquidity, flexibility, and overall financial performance.
All three of these financial statements are powerful tools that businesses use to develop a deeper understanding of their company, identify areas of improvement, and present to investors and lenders as proof of the company’s success to acquire loans and additional funding. Understanding each of these three documents individually and how they combine to paint the picture of a company’s financial success is an important step in being a business owner.
Contact our team today for further assistance.