Understanding Financial Statements
Understanding Financial Statements: A Guide for the Accounting Novice
For most business owners, financial statements are like insurance policies. Absolutely needed, but very intimidating to read. Don’t fret. In under five minutes, this blog will help make understanding financial statements much easier. And what can be simpler than putting everything in a question-and-answer format?
While the material here is mostly for the financial novice, there might be a few points in here for the more financially astute too.
Are you ready? Then let’s go.
Q: What are financial statements, and why should I care?
A: Financial statements are like report cards for your business. They show how well your business is doing financially—how much money you’re making, how much you’re spending, and what you or your business is worth. If you want to know whether your business is thriving, struggling, or just getting by, financial statements provide the answers. Plus, they’re essential for making informed decisions, getting loans approved, and keeping investors happy.
Q: What are the main types of financial statements?
A: There are three key financial statements you should know about:
- Income Statement (Profit and Loss Statement): This one tells you how much money your business made and spent over a specific period. It shows your revenue (income), expenses (what you spent), and whether you ended up with a profit or a loss.
- Balance Sheet: This statement gives you a snapshot of your business’s financial health at a specific point in time. It lists what you own (assets), what you owe (liabilities), and what’s left over for the owners (equity).
- Cash Flow Statement: This statement tracks the flow of cash in and out of your business. It shows where your money is coming from and where it’s going.
Q: What’s the difference between revenue and profit?
A: Revenue is all the money your business brings in from sales or services. Think of it as your total income before any expenses are taken out. Profit, on the other hand, is what’s left after you’ve paid all your expenses. It’s the money you get to keep. If your revenue is higher than your expenses, you’ve got a profit. If not, you’ve got a loss, and your statement will highlight this.
Q: What are assets and liabilities on the balance sheet?
A: Assets are everything your business owns that has value—like cash, inventory, equipment, and property. Liabilities are what your business owes—like loans, credit card debt, and unpaid bills. The difference between your assets and liabilities is your equity. This represents the owner’s share of the business.
Q: Why is the cash flow statement so important?
A: The cash flow statement shows the real movement of cash in and out of your business. Even if your income statement shows a profit, you could still run into trouble if you don’t have enough cash on hand to pay your bills. The cash flow statement helps you understand how cash is being generated and used, so you can manage your finances better.
Q: How often should I review my financial statements?
A: It’s a good idea to review your financial statements regularly — monthly if possible. This way, you can spot any issues like declining sales or rising costs early and take affirmative action before they become big problems. Regular reviews also help you stay on top of your cash flow situation and make sure your business is on track to meet its financial goals.
Q: What should I look for when reviewing my income statement?
A: Focus on a few key things:
- The Revenue trends: Are your sales increasing or decreasing? Why?
- The Expenses: Are there any expenses that seem unusually high? Can you cut them?
- The Profit margin: How much of your revenue is left after expenses? A higher profit margin means your business is more efficient at turning revenue into profit.
Q: How can the balance sheet help me make decisions?
A: When you make critical decisions about deploying your assets and liabilities, a balance sheet is a valuable tool. For example, if you have too much debt (liabilities) compared to your assets, it might be time to focus on paying down debt or finding ways to increase your assets. The balance sheet also shows your business’s liquidity—how easily you can cover short-term obligations with your current assets.
Q: What if my financial statements show a loss?
A: If your financial statements show a loss, don’t panic! It’s often a sign that you need to take a closer look at your business’s expenses and revenue streams to see what can be done. Ask yourself questions like:
- Are there unnecessary expenses I can temporarily or permanently cut?
- Can I increase my prices or find new revenue sources?
- Are there any seasonal factors affecting my sales?
Sometimes, a loss might just be temporary, but if it’s a recurring issue, it’s time to dig deeper and make some changes.
Q: Do I need an accountant to understand my financial statements?
A: While you can learn to interpret your financial statements on your own, having an accountant can be a tremendous help—especially if you’re new to accounting matters. A professional accountant can explain things in plain language, help you spot potential problems, and offer advice on how to improve your financial situation. Plus, they can save you time to work on other projects knowing your concerns are being looked after.
So, understanding financial statements doesn’t have to be intimidating. By becoming familiar with these key documents, you’ll immediately have a better handle on your business’s financial health. And remember, it’s okay to ask for help—whether from an accountant or a financial advisor—because the more you know, the better your business will do. And that’s something an insurance policy can’t do for you.