As a small business owner, you wear a lot of hats. One of those hats might be CFO, but even if it isn’t, you need to have a basic understanding of financial statements for small business and what each one tells you. Knowing how to read and understand financial statements is useful not only for your business but also for personal finances, work on volunteer boards, etc.
Financial statements will tell you how much money you have, how much money you owe, your income, expenses, profitability, and cash flow. The three core financial statements are the balance sheet, income statement, and cash flow statement. Understanding these reports can help you make better decisions and focus your energy on running your business.
Balance Sheet Basics
The balance sheet is a summary of what you have, what you owe, and the value of your business. It is created for a certain date, so it is a snapshot in time of your financial picture.
Your balance sheet will show you:
Liabilities + equity = Assets.
The two sides of the equations should balance (i.e. be equal to each other). That’s why it is called a balance sheet.
Assets are what your business owns. This includes cash, short-term holdings, inventory, prepaid expenses, and accounts receivable.
Liabilities are what you owe. This includes accounts payable, taxes, and debt, such as bank loans.
Depending on the structure of your business, equity will be listed in a different way. If you are a sole proprietor, then this entry is called “owner’s equity”. For corporations, equity is referred to as “shareholder’s equity.” Equity includes any capital invested by the owner or shareholders (i.e. money that you have put into the business) or retained earnings. Retained earnings is profit that has been reinvested in the business, rather than paid out to the owner(s) or shareholders.
Why is the balance sheet important?
The balance sheet is important because it tells you about the financial health of the business. A business whose liabilities are greater than its assets is in danger of going under.
Income Statement Basics
The income statement is also known as profit and loss statement (or P&L). It shows you your income less expenses. Where the balance sheet is a snapshot in time, the income statement covers a period, such as a month, quarter, or year.
The income statement shows business income and operating expenses. Product sales, freelance revenue, advertising revenue, services provided, etc. are all examples of business income.
The income statement is important because it tells you if your business is profitable or not. If your income exceeds your expenses, then you are profitable. If your expenses exceed your income, then your business is not profitable.
I recommend reviewing your income statement no less than monthly. This way you can stay on top of your profitability and make adjustments before it’s too late.
Cash vs. accrual accounting
As a small business, you have a choice of whether you use the cash or accrual method of accounting. If you do your own books, it’s likely that you use cash basis, but it’s worth a quick discussion here of the two methods so that you understand the difference. You must use one or the other – you can’t mix and match.
Under the cash basis method, you record income when the money is received and you record expenses when the money is paid. Under the accrual basis method, you record income when the sale occurs, regardless of whether you’ve been paid. The same thing for expenses. You record the expense when you make a purchase, even though you may not have been billed for it yet.
Let’s say you are a freelance designer who just got a contract to create branding, a website, and collateral materials for a photography studio. The total cost of the package is PKR 2,200 and you received half up front, with the remainder to be paid upon completion of the design package.
If you use the cash method of accounting, then you would record PKR 1,100 as income this month (half of the total amount of PKR 2,200). When you complete the project and receive the final payment, then you would record another PKR 1,100 as income at that time.
However, under the accrual method of accounting, you would record the whole PKR 2,200 as income this month, even though you haven’t received full payment yet.
It works the same way on the expense side. Let’s say you purchased a new laptop for PKR 1,500 and that you are going to pay for it in three installments of PKR 500 each (we’ll ignore interest costs for this illustration).
Using the cash method, you would record a PKR 500 expense each month for three months, when you actually make the payment.
Under the accrual method, you would record a PKR 1,500 expense this month, when you take the laptop and become obligated to pay for it.
Your income statement will be different depending on whether you use the cash basis or accrual basis method of accounting.
If you use accrual basis accounting, then there is one more financial statement that you need to review – the cash flow statement.
Cash Flow Statement Basics
The cash flow statement (aka Statement of Cash Flows) reports all transactions where cash actually flows into or out of your business. In other words, when you received a payment or you made a payment. Like the income statement, the cash flow statement is prepared for a period of time – typically monthly, quarterly, or annually.
If you use the cash method of accounting, then your income statement and cash flow statement would be the same. If you use the accrual method of accounting, then your cash flow statement may be quite different from your income statement.
Cash flow is important because it reflects whether or not you can meet your obligations. If you have income that has accrued but hasn’t been received, then you might not have enough cash to meet upcoming expenses, like payroll, paying your virtual assistant, or paying a recurring subscription service.
Should you decide to apply for a loan, then the bank will look at your cash flow to determine if you can make the loan payments.
Your financial software should be able to provide these financial statements to you. With any of the financial statements, you can go as high-level or as detailed as you want. Reviewing them regularly will give you a better understanding of the financial health of your business. And that will help you run your company and make better decisions.
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