The Beginner’s Guide to Understanding Financial Statements
October 18th 2019 at 12:28pm Published by sharpshooteradmin
If you’re running a small business of your own, we hope that you know one thing for sure by now; there is no way around understanding financial statements. If you want your business to succeed, you should make sure that you maintain a stringent check on your financial statements and the information within it. Keeping an eye on your financial affairs can save you a lot, while also allowing you to be proactive in dealing with any upcoming problems.
While you should keep tabs on your financial statements to keep your business running flawlessly, the law has also tightened up on this regard. The law currently requires entrepreneurs to take all responsibility when it comes to maintaining their financial statements and ensuring that the information presented in it is void of any errors whatsoever. You need to take up this responsibility and should have your eyes set on the end goal of financial security.
Well, with this introduction you might think that the information in this article is only meant for business owners. But, don’t let your haste take over just yet. The information we present here is meant for every trader, every professional, every stakeholder linked with a business and every finance student. You need to understand that the world of business finance is heavily dependent on financial statements and the information that they carry. The information present within financial statements is what defines the success of any organization.
Before we discuss the importance of financial statements in more detail, we will first take a look at the different types of financial statements present inside a business.
Types of Financial Statements
If we study the records of businesses and the basics of finance, we understand that there are four basic types of financial statements. All of these financial statements have their own role to play in helping you run a business the way you want. If you want your business to succeed, you should make sure that financial statements you manage are made in a tranquil manner, without any deficiencies as such. It is necessary that you take the financial safety of your business while preparing these statements.
The 4 types of financial statements include:
- The balance sheet
- The income statement
- The cash flow statement
- The statement of owner’s equity
All of these statements have their own role to play in running your business. The information presented within these financial statements could be of great importance to you based on the kind of goals that you are looking to achieve.
We study all of these statements in great detail below for a better understanding of the concepts that are at play here.
If we were to rank financial statements in order of the importance that they carried, then the balance sheet would definitely rank at the very top. The balance sheet is by far the most important piece of paper for a business. Not only does the balance sheet help the business in finding out the financial accuracy of all of their records, but it also helps small business owners in seeing just how they are doing in terms of assets, liabilities and capital.
For those who are completely new to this concept, the balance sheet is based on one of the most important principles of accounting, which is that all of your assets should follow this equation: Assets = Liabilities + Capital. All the liabilities and the capital that you have in your business should total to form the figure for your assets.
Thus, when it comes to drafting a balance sheet, you are just trying to prove this equation correct. As you could have told through the equation above, the balance sheet is broken down into three parts. Every part has an importance of its own. The three parts consist of assets, liabilities and capital.
You start your balance sheet by listing down the assets and then breaking the assets into two multiple parts. The two parts you break your assets into, include current assets and non-current assets.
The current assets section for your business includes all assets that you can sell off or replace with cash within a period of a year. These current assets are known to be highly liquid, because you can easily transfer them with cash if the need be. The current assets include cash in bank, cash at hand, inventory at hand, account receivables and prepaid among many other items. You mark them separately from non-current or fixed assets because of their nature.
Non-current assets or fixed assets happen to be different from current assets in ways more than one. For starters, fixed assets happen to have a greater life than a year. Your fixed assets, unless you decide to sell them off, will remain with you for more than a year. The interesting part about your fixed assets is that you have to calculate depreciation on them. Since you’re holding these assets for such a long period of time, you have to calculate depreciation on them. Depreciation is the accounting principle, owing to which you have to deduct a specific amount from the value of your fixed assets upon use. Let’s say you purchased a motor van for $20,000 to manage business delivery purposes. When you sell the vehicle off after 5 years, it will sell at a lower rate than what you first purchased it for. Hence, rather than taking the full brunt of the loss in one go, you should make sure that you keep preparing for the reduction in price by calculating depreciation. While all other fixed assets depreciate, land is the only asset that can appreciate based on dynamics of property and the value associated with it in the market. Your fixed assets include land, property, building, equipment, motor vehicle, machinery, fixtures and computers.
Liabilities can be defined as the debt that your business owes to private or federal funders. From the purchases you made at credit to the debt you owe to a friend, everything is included inside the section for liabilities in your balance sheet.
The liabilities you have are also divided into current and non-current liabilities. Liabilities that need to be paid back within a year are known as current liabilities, while liabilities that should be paid back after a year or known as non-current liabilities. Current liabilities include your creditors, accrued payments on an expense and other short term debts. The long-term liabilities or the non-current liabilities happen to include liabilities that last for a longer term. These liabilities happen to require interest payments as well at times. And, the interest is recorded in the expenses.
When you have jotted down both the assets and the liabilities, you write down the owner or shareholder equity in the final slot. The owner equity includes all of the money that has been invested inside the business by the owner or by shareholders. This money is invested as a startup amount and is imperative for the growth of the business you are running.
The balance sheet can be quite complex to make, but if we consider all the benefits that it carries, there is no reason why you should shy away from taking interest in the process. The slightest mistake cannot just damage your financial figures, but it can also end up misinterpreting the growth curve of your brand.
The income statement is the second most important document or statement for your business after the balance sheet. We hype up the income statement, because it tells you one of the most important metrics required for running a business; your profits.
The income statement is where you jot down all sales and expenses for a period and compute them accordingly to see how much profit you’ve made in that particular period.
The income statement gives you two figures for profit. The first figure, which is off gross profit, is directly generated after subtracting the cost of goods sold from the value for revenue. In short, the gross profit is the basic gain you have made on the merchandise you sell.
Once you have the figure for gross profit with you, you subtract your operational expenses from that figure to get the figure for net profit. Net profit is the net or final gain that you have made in a specific period. It is necessary for your business as it gives you an idea of the progress you have made over a period of time. The net profit is important for your success, as it is the value that is then transferred to the balance sheet.
If you aren’t able to make a profit during a specific period, then the net profit would be replaced with a net loss. This will happen when your expenses happen to be more than the gross profit that you have made. Businesses operating at a net loss have a lot to consider, including the financial stability of your business.
Cash Flow Statement
While we have discussed the importance of studying profits above, we think that cash is an even important reserve for most businesses. Cash is tangible and can be actualized, whenever you want, unlike the case with profits.
The profits you make are intangible and are calculated through the revenue you make. The figure for revenue itself includes both cash sales and credit sales. If more than half of your sales are credit sales, then you could be running into a cash crunch, despite your profits being sufficient.
Thus, the income statement can by itself not be a good indication of the state of your business. When it comes to studying the financial well being of your business you need to look beyond the income statement at the cash flow statement.
The cash flow statement is basically used for recording and mentioning the flow of cash inside and outside your business. Every transaction that you make involving cash is recorded inside this statement. By the end of your financial year you can analyze the cash flow statement to find where your cash has been going. The cash balance you have on your hands is another metric that can help you understand the value of your business currently. You should take into consideration the cash balance showed by the cash flow statement at the end of the reported period.
Now, while the cash flow statement is in itself a good way of keeping an eye on your cash reserves, we believe that there is no better way to manage your cash flow than through the use of a cash flow projection statement. The cash flow projection or forecast is made to help you project your cash flow statement for the period to come. This can help you see just what kind of expenses you will be making in the future and how they impact you. The cash flow projection statement is believed to be a key part of your business because it can help you identify the need for funding options such as small business funding or merchant cash advances. You can check your cash flow forecast to identify just when you would need these funding options for your business. If the forecast predicts a cash crunch in the coming future, then you can be on your toes and get small business funding from a private funder in time, rather than waiting for the inevitable to strike.
Statement of Changes in Shareholders’ Equity
The fourth and final statement we have in this list is mostly concerned with private limited or public limited companies. These are companies that sell their shares to the general public and have multiple shareholders or owners.
At the end of the year, all of these public or private limited companies need to make a statement finding out the changes that have transpired on their equity. The statement should look to make a summary of all these changes for a given period.
All of your shareholder equity is grouped according to the importance it holds within this statement. You need to keep an eye on shareholders equity and this statement is the best way of doing so.
Importance of Financial Statements
Now that we have discussed the different financial statements it is time to shed some light on the importance that they hold. All financial statements hold a separate importance when it comes to how your business is run. You should make sure that you study the importance of these statements in full detail, so that you are properly motivated towards maintaining them in the long run.
Importance to the Management
Before heading to study the importance of these statements to other stakeholders, we study the importance that these statements can have to the management. We understand the complexities involved in running a business, and are fully aware of what it feels like to lose control over finances.
Your finances play an important role in how your business is run, which is why the slightest discrepancy in these finances can scare you. These statements act as a litmus test of sorts, as they allow you to gauge the success of your business over a period of time. You can study the success of your business, while taking the pertinent measures required for achieving full control over the finances.
To start off with, the income statement and the cash flow statements are of the greatest concern to the management. As an entrepreneur, your task is to take risks and to hope that these risks pay off. Now, if you don’t have your eyes fixated on the financial benefits of these risks, then you could be missing out on a lot. You need to know just how important it is for you to remain honest to the business you are running. You should take calculated risks at all times and should take both your statement of cash flows and your income statement into perspective while taking these risks.
Both the statements above give you an indication of the financial readiness of your business towards a particular move. They also help you locate how the business is responding to the previous steps you have taken for improving cash balances and profits.
The balance sheet also concerns the top management, as it helps them decide whether they need to go for debt financing options or not. Debt financing is one of the most sought after options of financing in business, and you can only go for it once you are sure that your business is ready for such a funding. You need to be sure about the readiness of your business for debt financing, because this would help you identify the success of a liability or funding.
To the Shareholders
Shareholders invest money into your business, which is why they are concerned with many factors concerning your business. The income statement and the balance sheet are of primary importance to shareholders because these help them realize what kind of return they can expect on the investment they have made in your business.
Once the balance sheet and income statement are present in front of your shareholders, they can run multiple tests on the figures present within to see the financial feasibility of your business. Shareholders will only continue investment in your business if they feel that the business is profitable enough to pay off all shareholders.
The EPS or earnings per share ratio is one ratio that most shareholders use for computing the financial readiness of your brand for handling shareholders and the investment they have put into your business. To calculate the earnings per share ratio you need the total number of shares that the business has sold and the exact net profit after tax. Once you divide the after tax and interest earnings of the business by the total number of shares, you can get to know the earnings per share ratio.
Shareholders don’t think twice before comparing businesses on the basis of the earnings they are making per share. The earnings per share ratio helps give solid insight into how a business is currently run, and what it can do for better stats in the future. Shareholders can also use this ratio to find out the benefit of investing in a particular business.
Importance to Other Stakeholders
All the statements that you maintain within your business can have separate importance for all stakeholders associated with your organization. The importance of these statements for these stakeholders is:
Employees can need business information for multiple purposes. The first out of these purposes is to identify how the business can help them out in securing future appraisals. If the business has a good current standing, they can secure better appraisals in the time to come by working tirelessly in their current roles. On the flipside, if the business isn’t doing good business, employees would want to identify the trends and start looking for opportunities elsewhere.
The government or the state you operate in would directly be interested in the revenue that you are generating through your business. The government would be interested in these statements because they would like to see the profits you are generating for taxing you accordingly. The government can also take your business statements into consideration for measuring the performance of small businesses in general or within your government sector.
Suppliers can also study your business statements for understanding the potential business that you can bring to them. A good understanding of your business can help suppliers give you the best rates possible for future growth.
All of the information that we have mentioned above is meant to help you get the most out of your business statements. Your business statements narrate the success of your business and you should be looking to leverage this information for helping position your small business in the best light possible.