The Essential Guide to Financial Statements for Business Owners

Business owners need to stay on top of their cash flow, profitability, and liquidity to keep the business financially sound and make informed decisions. Financial statements are a tool for doing just that.

The four primary financial statements—balance sheets, income statements, statements of cash flows, and statements of owners’ equity—provide vital information about a company’s financial health and performance.

Do you get your monthly financial statements from your accounting software or bookkeeper and stick them in a drawer? If so, let’s make the resources you invest in preparing those financial statements worthwhile by outlining each statement, what it’s telling you, and how you can use it to make changes in your business.

Four Main Financial Statements Every Business Needs

Financial statements are essentially a set of documents showing your company’s financial position and results of operations at a specific point in time. Let’s look at those four core financial statements in more detail.

Balance Sheet

The balance sheet, also known as the statement of financial position, provides a snapshot of your assets, liabilities, and equity at a specific point in time. It’s based on the accounting equation:

Assets = Liabilities + Equity

To understand your balance sheet, you need to understand these three parts.

• Assets. Assets are resources you own, such as cash, accounts receivable, inventory, and fixed assets. Assets may be current (able to be converted to cash within a year) or non-current (long-term assets).
• Liabilities. Liabilities represent money owed to external parties. They include accounts payable, accrued expenses, notes payable, and other debts. Like assets, liabilities are classified as current and non-current.
• Equity. Equity represents the owners’ residual interest in the company after deducting all liabilities from its assets. It includes common stock, retained earnings, and additional paid-in capital. It’s important to understand that equity isn’t necessarily the value of your business. Instead, it’s what would remain if you had to liquidate today, using assets to pay off debts.

Your balance sheet can provide insight into your business’s liquidity, asset performance, and capital structure.

For example, you can use the numbers in your balance sheet to calculate your current ratio.

Current Ratio = Current Assets / Current Liabilities

Your current ratio evaluates your ability to pay off your short-term liabilities (accounts payable, accused expenses, and the current portion of long-term debt) with your short-term assets, like cash, receivables, and inventory.

In general, a current ratio of 1.5 to 2 is ideal. Anything below 1 could indicate liquidity problems.

Income Statement

The income statement, also known as the profit and loss statement (P&L), summarizes your revenues and expenses over a specific period—typically a month, quarter, or year. It calculates your net income by subtracting expenses from revenues.

Here are the main items you’ll find on your income statement:

• Revenues. Revenue is the total income generated from sales of goods or services before deducting any expenses.
• Cost of Goods Sold (COGS). COGS is the direct costs of producing the goods and services you sell. It can include direct labor, materials, freight and shipping, storage costs, and factory overhead.
• Gross Profit. Gross profit is revenues minus COGS. It indicates the profitability of your core business operations.
• Operating Expenses. Operating expenses are costs incurred during normal business operations. They can include salaries, rent, licenses, professional fees, marketing and advertising costs, and utilities.
• Net Income. Net income is the final profit or loss after subtracting all expenses, including income tax payments and interest expense, from total revenues. A positive net income indicates profitability, while a negative net income—also known as a net loss—means you spend more than you bring in.

One way to evaluate your profitability using the income statement is by looking at the trend of revenues and expenses over time. It’s common for expenses to outpace revenues in the early stages of launching a business. But if your costs continue to go up while revenue falls or remains flat, you need to make some changes.

Statement of Cash Flows

The statement of cash flows reports the inflows and outflows of cash and cash equivalents during an accounting period. It helps you understand how your business generates cash and how you spend it for operating, investing, and financing activities.

Your cash flow statement shows cash broken out into three areas:

• Operating activities. Operating activities are cash flow from daily business operations, including receipts from sales and payments to suppliers and employees.
• Investing activities. Investing activities include cash flow related to acquiring and disposing of long-term assets, such as property and equipment. It also includes investing in other companies.
• Financing activities. Financing activities include cash flow from transactions with the company’s owners and creditors. These transactions might include issuing stocks in exchange for cash, selling bonds, taking out loans, or repaying debts.

The operating activities section is one of the most important sections to look at in your cash flow statement. It’s usually the first section of your cash flow statement. Positive cash flow from operating activities is crucial for sustaining business operations.

Another helpful metric is your free cash flow.

Free Cash Flow = Operating Cash Flow – Capital Expenditures

This metric shows how much money remains after supporting business activities and paying for capital expenditures, like buying real estate and equipment. It’s a good indication of whether you have the money to pay off debts, pay dividends to shareholders, or invest in growth and expansion.

Statement of Owners’ Equity

The statement of owners’ equity, sometimes called the statement of changes in equity or the statement of shareholders equity, outlines the changes in the owners’ equity over a specific period. It provides insight into how you invest profits and the effects of other equity transactions.

This is usually the shortest and simplest financial statement, as it shows:

• Beginning equity. This is the total equity at the start of the period.
• Additions. Additions to equity include contributions made by owners, retained earnings (profits retained in the business), and any new stock issued.
• Deductions. Deductions from equity include withdrawals made by owners, dividends paid, and losses incurred during the period.

The shareholder equity statement reveals how much of the net income the business retained versus how much it distributed to owners. A growing owners’ equity indicates a healthy reinvestment strategy while declining equity can signal potential financial troubles.

Do you need help interpreting your financial statements?

Financial statements and other financial reports can be an indispensable tool offering vital insights into your company’s financial performance, the company’s assets, and how much your company owns and owes. But they’re only useful if you know how to interpret them.

If you need help preparing financial statements and using them or performing financial statement analysis, contact Percipio Business Advisors. We’re happy to help with understanding financial statements and using them to make informed decisions that drive growth and profitability.

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