Financial statements are essential documents that businesses worldwide must use to record, monitor, and analyze their finances. Knowing how to read and make sense of the financial data displayed in these statements is a must for any business owner.
This article will help you gain a basic understanding of financial statements, learning how to read and comprehend the information presented within these essential documents.
What is a Financial Statement?
A financial statement is a document that a business will create to display their financial status in a given accounting period. These statements must be periodically updated with the latest data to provide a comprehensive and accurate snapshot of the business’s finances.
Understanding a financial statement starts with reading the document and knowing where the business’s money is coming from and going to. Once you can discern what the figures represent and how it reflects on the company in question, you can analyze the business’s profits and losses to determine how well they are doing within the market industry.
The most important financial statements of a business are the income statement, balance sheet, and cash flow statement. So let’s take a look at each one individually and break down the information therein.
How to Read an Income Statement
An income statement illustrates the amount of revenue a business has generated within a specific accounting period. This monthly, quarterly, or annual report highlights the profit and losses of the company; that’s why this document is also referred to as a profit and loss statement. Reading this document, you can decipher a company’s financial trends and business activities to compare against the previous period’s statements.
To read an income statement, you will need first to understand the items listed within the document. Listed below are these concepts in order of where they appear on the statement, starting at the top:
- Gross Revenue/ Gross Sale: The total amount of money a company has made in the specified period- brought in through the sales of their goods or services. This ‘gross’ amount is the total amount of revenue before expenses have been deducted.
- Returns and Allowances: Refer to the money a company will lose from sales, such as discounted prices and customer returns.
- Net Revenue: This figure is the amount left over after the company has subtracted its returns and allowances from its gross revenue.
- Costs of Goods Sold: Also known as COGS; this figure represents the amount of money a business spends on the production and purchase of the goods they plan to sell.
- Gross Profit/ Gross Margin: A business will subtract its COGS from its net revenue to determine the amount of money left over.
- Operating Expenses: These are the costs the business must pay to run accordingly every month. Such expenses include paying for rent, inventory costs, employee wages, and the like, but are not associated with the COGS.
- Depreciation/ Amortization: Found under operating expenses, depreciation, or amortization, refers to the business’s use of assets over time. A company will spread the cost of an asset over a period of time, such as machinery or equipment, costing a fraction of the total price over the length of its lifetime.
- Income from Operations: This figure represents the business’s operating profit after all operating expenses have been deducted from gross profit.
- Interest Income and Interest Expenses: Interest income refers to the interest made off interest-bearing savings account businesses might have. In contrast, interest expenses refer to the money a company will pay as interest on loans. The two will sometimes be listed together or separately on the document depending on the business. These figures are then added or subtracted from the operating profits.
- Income Tax: The money a company must pay in taxes to the government from their net income; this is the final deduction made on the statement
- Net Profit or Net Loss: This is the bottom line of an income statement, the final amount a company will have made or lost in the accounting period after all taxes and expenses have been deducted.
To learn how to create this document, check out this guide on income statements with template.
How to Read a Balance Sheet
The balance sheet, also known as a statement of financial position, displays an overview of the company’s assets, liabilities, and equity. This document helps internal and external entities determine the financial health of the company in question. A balance sheet is divided into a left side, where all assets are listed, and the right side, where all liabilities and equity are listed.
Assets refer to any item of value owned by a business. Assets are divided into short term assets and long term assets on the balance sheet. Short term assets, also known as current assets, refer to the business’s assets that last less than five years, typically cash, accounts receivable, securities, bank accounts, inventory, and equipment.
Long-term assets, or non-current assets, are a business’s assets that last for a more extended period. Long-term assets include fixed assets, such as large machinery and equipment, and the business’s property or real estate, as well as long-term investments.
Liabilities, on the other hand, are debts or money that must be taken out of the company to pay for expenses. Liabilities are divided into short-term and long-term, just like assets. Short-term, or current liabilities, refer to the business’s debts that can be settled within the period or fiscal year, including accounts payable, operating expenses, and payroll. Long-term liabilities, or non-current liabilities, cover the business’s debt that goes beyond a year, such as business loans or mortgages.
Shareholder’s equity/owner’s equity
Equity can be found on the right-hand side of the balance sheet below liabilities. Equity refers to the amount of money belonging to you, as the owner, within the company. If the business is incorporated and has shareholders, then the equity also refers to the funds held by other shareholders within the company.
As the name suggests, a balance sheet must balance out both the right and left sides. Meaning, the total assets must equal the total liabilities and equity of the business in question. Your business can use this balance sheet template to create a statement of financial position.
The numbers and figures represented in this document can vary greatly depending on the company’s industry. The diverse nature of the market means that these documents will also possess a diverse range of financial information.
How to Read a Cash Flow Statement
Cash flow refers to the money coming in and out of a business. The cash flow statement outlines the changes in this cash over the specified period to determine the financial performance of the business. Cash inflow happens when a company generates revenue or interest on investments. Cash outflow occurs when a company pays for expenses, such as operating costs of the business.
The cash flow statement uses and reorders the information from the balance sheet and income statement to depict the overall cash inflow and outflow of the business. This statement is divided into three parts, referring to the cash generated by:
- Operating Activities: Money generated by the primary operations of a business as well as expenses covering the same operations
- Investing Activities: Money generated and lost by the business’s investments
- Financing Activities: Cash flow surrounding the debt and equity of the business
Finally, from the three activities, a business can determine the net increase or net decrease in cash for the accounting period in question. A net increase means a positive cash flow for your business, meaning you have more money coming into the company than it does leave the company. A net decrease means your business possesses a negative cash flow; therefore, you are losing more money than generating.
Your business can use this cash flow statement template when creating this document.
Tips When Reading Statements
A business’s income statement, balance sheet, and cash flow statement offers individuals an immense amount of information if they know how to understand it. Yet, understanding financial statements can be an intensive process. Here are a few more tips to consider when absorbing the information in your business’s statements.
Be aware of the footnotes
Financial statements will typically be packed with footnotes that provide further information on the documents’ figures. Don’t just skip over this small print located at the bottom of the page, as you could miss essential data such as applicable accounting policies and practices, income tax deferrals, pension plans and retirement programs, and stock options for those working within the company.
Know your ratios
The figures and numbers presented in these statements can be hard to relate to the bigger picture. Therefore, much of the data will need to be presented in a way that creates a relationship between the figures on the page and what that means for your business. Ratios help investors understand the information in a way that is relevant to the company and industry.
Therefore, be aware of these financial metrics and what inventory turnover ratio, operating margin percentage, the price per share ratio, and debt-to-equity ratio can tell someone about your company’s financial position.
Read separately, but provide a picture as a whole
For a complete understanding of financial statements, you will need to read the statements separately but consider the information as a whole. The figures representing assets and liabilities on the balance sheet will directly impact the revenue and expenses on the income statement. Even though you will read these financial statements separately, they are intimately linked to portray a cohesive overview of a company’s finances.
Use accounting software to help your business generate its financial statements
Does your small business need help creating financial statements and reporting on their information? Let QuickBooks Online do the heavy lifting with its accounting know-how as it syncs with your business accounts and automatically tracks expenses and revenue in real-time. Using this information, the software will generate your income statements, balance sheets, and cash flow statements to help you with your financial reporting.
Try quality accounting software for free today!