How to read financial statements [beginner-friendly guide]

Financial statements act as a compass that steers you toward informed financial decisions. By delving into the balance sheet, income statement, cash flow statement, and nonprofit financial statement, you gain a comprehensive understanding of your small business’s financial health. 

Our beginner-friendly guide sheds light on these essential documents, making financial literacy achievable for the everyday solopreneur. Plus, take a look at our examples of how each document operates in the real world.

How to read a balance sheet

The balance sheet is a fundamental financial statement that provides a snapshot of a company's financial position at a specific point in time. It shows what a company owns (assets) and what it owes (liabilities). Imagine it as a photograph of your company's finances on a particular day.

Let's break down the key components of a balance sheet:

• Assets: These are all the resources a company owns that have economic value. They are typically listed in order of liquidity, meaning how easily they can be converted into cash.
• Liabilities: These represent the company's financial obligations—what it owes to creditors. Liabilities are generally categorized as short-term or long-term.

Understanding a balance sheet is crucial for anyone analyzing a company's financial health. It reveals how much cash a company has on hand, how much it owes to creditors, and the value of its investments.

Balance sheet example

A review of a company's most recent balance sheet reveals a notable increase in cash and short-term investments compared to the prior year. This positive trend suggests a robust generation of cash flow, potentially driven by a recent product launch or a surge in sales. However, a corresponding rise in accounts payable is also evident. This could signal the company is taking on more debt from suppliers to fuel its growth.

How to read an income statement

An income statement, also known as a profit and loss statement, reveals how much money a company earned in revenue and how much it spent on expenses during that time frame—ultimately showing its profitability. 

Let's dissect the key components of an income statement:

• Revenues: This represents the total income generated by the company from its core operations, such as selling products or services.
• Gains: These are non-operational income sources, like income from investments or the sale of assets.
• Gross profit: This is calculated by subtracting the cost of goods sold (COGS) from the total revenue. 
• Expenses: These are the costs incurred by the company during its normal course of business, such as rent, salaries, marketing, and administrative expenses.
• Losses: These are non-operational expenses, like unexpected write-offs or losses on investments.

By analyzing these components, you can gain valuable insights into a company's profitability, its operational efficiency, and its overall financial health.

Get actionable insights from your income statement with expert help through QuickBooks Live.

Income statement example

A bakery reviews its income statement and notices a steady increase in revenue year over year, reflecting strong customer demand. This is positive news. However, they also see a rise in expenses, particularly for ingredients like flour and butter due to inflation.

While the revenue growth is commendable, the rising ingredient costs could potentially squeeze their profit margins. This situation might prompt the bakery to explore alternative suppliers, renegotiate contracts, or slightly adjust their pricing strategy to maintain profitability.

How to read a cash flow statement

The cash flow statement is a financial document that shares a company's cash inflows and outflows over a specific period. Unlike the income statement, which focuses on profitability, the cash flow statement highlights a company's ability to generate and manage cash.

A cash flow statement is typically divided into three main sections:

• Operating activities: The cash flow generated from a company's core business operations, such as cash received from customer sales and cash paid to suppliers via inventory purchases.
• Investing activities: The cash flow associated with a company's investments, including purchases or sales of property, plant, and equipment, or investments in securities.
• Financing activities: The cash flow from a company's financing activities, such as issuing new debt like loans, equity in stock, and repayments of existing debt.

By analyzing these sections, you can gain valuable insights into your business’s cash flow generation, its investment strategy, and its reliance on debt financing.

Cash flow statement example

The bakery generates a healthy positive cash flow from its core operations ($95,000), indicating it effectively collects revenue from customers and manages its day-to-day expenses for ingredients, staff, and utilities. This positive operating cash flow likely allows them to cover ongoing business costs and potentially invest in future growth.

Moreover, the investing activities section of the cash flow statement shows us a new oven purchase of $30,000 is recorded. The bakery likely financed this purchase through a loan, reflected in the $20,000 outflow under cash flow from financing activities. While this loan repayment reduces their overall cash increase for the year, it also positions them for potentially higher baking capacity in the future.

How to read a nonprofit financial statement

Nonprofit accounting requires examining your financial statements, but these documents differ slightly from those used by for-profit companies. While both present financial information, for-profit statements prioritize profitability, while nonprofit statements focus on mission fulfillment and responsible resource management.

Let's explore the key components of a nonprofit financial statement package:

• Statement of financial position (balance sheet): The organization's assets and liabilities. Unlike a for-profit company with shareholder equity, a nonprofit's net assets represent the cumulative contributions and retained earnings used to fund its mission.
• Statement of activities (income statement): Revenue sources like donations, grants, and program fees and expenses. Unlike a for-profit income statement, the nonprofit statement of activities shows how efficiently resources are used to achieve its mission.
• Statement of cash flows: Similar to a for-profit statement, this document tracks the organization's cash inflows and outflows over a period. It reveals how well the nonprofit manages its cash and ensures sufficient funds are available to support its programs.
• Statement of functional expenses: This statement, unique to nonprofits, categorizes expenses by the programs or services they support. This allows stakeholders to understand how resources are allocated across different initiatives.

By analyzing these core statements and their accompanying notes, readers gain valuable insights into a nonprofit's financial health, its efficiency in achieving its mission, and its overall accountability to its donors and the community it serves.

Nonprofit functional expenses example

Reviewing the financial statement of an animal shelter, we can see a breakdown of their funding sources in the statement of activities. Donations from individuals and grants from foundations likely make up a significant portion of their revenue. The Statement of functional expenses might reveal that most expenses are categorized under "Animal Care," including costs for food, veterinary services, and shelter maintenance.

This level of transparency allows donors to see how their contributions directly impact the well-being of animals. Moreover, a positive net cash flow in the statement of cash flows indicates that the shelter is generating enough cash to cover its operating expenses and potentially invest in future expansion efforts.

Have questions about understanding your nonprofit’s cash flow? Ask an expert at QuickBooks Live to get started.

Tips for reading financial statements 

Financial statements can be intimidating documents filled with numbers and technical jargon. However, with a little effort, you can unlock valuable insights into your business’s overall financial health and performance. Here are key tips to guide you through this process.

Always read the footnotes 

Financial statements themselves provide a wealth of information, but the footnotes hold hidden treasures. These seemingly dull pages often contain crucial details that can significantly impact your understanding of the company's financials. 

Look out for the following in the footnotes:

• Company policies: Accounting policies can vary between companies. The footnotes explain how the company recognizes revenue, values inventory, and depreciates assets. Understanding these policies allows for a more accurate interpretation of the financial figures presented.
• Income taxes: The footnotes typically detail your tax expenses and any potential contingencies related to taxes. This information is essential for assessing the company's true profitability after accounting for tax obligations.
• Stock options and retirement plans: Companies often grant stock options or contribute to employee retirement plans. The footnotes disclose the financial impact of these programs, affecting the company's reported expenses and net income.

By carefully reviewing the footnotes, you gain a more comprehensive picture of the company's financial position beyond the headline numbers.

Look for patterns, not just numbers

Financial statements are a historical record, but they also offer a glimpse into the future. Don't get bogged down in analyzing every single number. Instead, pay special attention to patterns within the data across different reporting periods. 

Are revenues consistently growing year-over-year? Are operating expenses under control? Have profit margins been steadily increasing or declining? Identifying trends allows you to spot areas of strength and weakness, potentially revealing the company's future trajectory.

Keep context in mind

Financial statements shouldn't be analyzed in a vacuum. When interpreting the data, consider both internal and external factors that might influence the company's performance. Internally, has there been a recent change in management or a restructuring within the company? Externally, are there any industry-wide trends or economic factors affecting the company's operations?

For instance, a significant drop in sales for a retail company might be due to a company-specific issue like a product recall. However, it could also be a result of a broader economic downturn impacting consumer spending across the industry.

8 financial statement red flags

Now that you know how to read financial statements, here are eight red flags that can indicate trouble for a business.

1. Rising debt-to-equity ratio: If over 100%, it indicates excessive debt. Also, a falling interest coverage ratio below five is concerning.
2. Several years of revenue trending down: Three or more years of declining revenue suggest poor investment potential.
3. Large “other” expenses on the balance sheet: High values in “other expenses” may be investigated for recurrence.
4. Unsteady cash flow: Irregular cash flow can indicate financial instability.
5. Rising accounts receivable or inventory in relation to sales: Excessive accounts receivable or unsold inventory can hinder returns.
6. Rising outstanding share count: A rising share count dilutes shareholder value.
7. Consistently higher liabilities than assets: Consistently more liabilities than assets indicate over-leveraging.
8. Decreasing gross profit margin: A declining margin signals financial trouble.

Be on the lookout for these warning signs next time you perform a bookkeeping cleanup.

Spend more time growing your business

While learning how to read financial statements may appear complex at first glance, they offer a powerful tool to understand a company's financial health and its potential for future success. By following these bookkeeping tips you can unlock impactful insights.

Financial statements can be even more accessible and user-friendly with the help of accounting software. Many accounting software programs can automate the process of data entry, generate financial statements with a click of a button, and even offer visual representations of the data through charts and graphs. This can save you significant time and effort, allowing you to focus on analyzing the information and making informed decisions.