Understanding Your Business Financial Statements: A Beginner’s Guide

Understanding your business’s financial statements is crucial to understanding the health, progress, and performance of your business, but not everyone goes into business knowing the ins and outs of these reports. Many entrepreneurs start their businesses without a strictly “business” or accounting background, so they learn as they go. But something that would be advantageous to learn about early on is how to read and understand your financial statements, even if you’ve teamed up with an outside accountant to handle that side of things. As an accounting firm that works with and supports small businesses, we’ve written the following beginner’s guide to understanding the major financial reports for your business.

What are Business Financial Statements?

Your business’s financial statements are reports that together paint the picture of how your business is performing and operating. If you are handling your own bookkeeping, you may generate these reports from the software you’re using, such as QuickBooks. If you’ve hired a good accountant or bookkeeper, they should send you financial statements regularly for you to review.

These reports are important to review because they give you a snapshot of how your business is doing, help you spot trends, and allow you to see if you are making progress toward your business’s financial goals. If you only look over these reports once a year (such as around tax time or year-end) or even once a quarter, you may miss out on important data and signals. We recommend reviewing your business’s financial statements monthly.

The most common and frequently utilized financial statements are a Profit & Loss Statement, a Balance Sheet, and a Cash Flow Statement.

Important Note: These reports are only as helpful and accurate as the data that is put into them. It is crucial that accounts are classified correctly when setting up the chart of accounts. If you want assistance setting up your business’s books correctly, contact us for help.

The Three Main Business Financial Statements

Now, these are not the only types of financial statements out there, nor are they the only tools for tracking and analyzing your business’s performance. But generally, the Profit & Loss Statement, Balance Sheet, and Cash Flow Statement are the pillars for easily reviewing the financial health of your business. Each of these reports serves a different purpose. Also, a Balance Sheet shows a snapshot at a particular moment in time, while both Profit & Loss statements and Cash Flow statements show the results over a specified time period.

Profit & Loss (P&L)

You might see a Profit & Loss statement also referred to as a P&L or an Income Statement, and this type of report shows you your business’s income, expenses, and net income (income minus expenses) for a specific time period. Detailed P&Ls typically break income and expenses into categories based on how transactions have been classified; for example, your Expenses section might include categories such as Advertising, Professional Fees, Subscriptions, and Office Supplies. Typically, your profit, or net income, will be shown at the bottom of this statement.

Why it matters: A P&L can help you see trends over time in your business, especially when you compare multiple months, quarters, or years. For example, if you were to compare income statements for April, May, and June, you might notice growing expenses or decreasing revenue that need to be addressed or investigated further.

Balance Sheet

Your business’s Balance Sheet is a “statement of financial position” (and therefore is sometimes referred to as that). This statement will show the balances of your business’s assets, liabilities, and equity. Very simply, assets are what your business owns (can be tangible or intangible), liabilities are what your business owes, and equity represents the value of the business or its net worth.

As previously stated, this financial statement will only be as good as the initial setup and underlying data input into it, so it’s important that you understand the difference between these types of accounts and expenses both when setting up the chart of accounts and when categorizing transactions.

These 3 major components of the Balance Sheet work together in this foundational accounting formula:

Assets – Liabilities = Equity

Basic glossary of terms on a Balance Sheet:

• Assets = Things that are owned, for example, cash or equipment. It also includes Accounts Receivable (revenue earned but not yet converted to cash).
• Liabilities = Things that are owed, for example, Accounts Payable or debt. A liability is different from an expense because a liability represents something that has not been paid with cash yet, such as a bill, or a long-term liability, such as a loan.
• Expenses are incurred in a business in order to earn revenue during a particular period, whereas assets or liabilities are items that either benefit or will be incurred over periods of time rather than immediately.

Why it matters: Your business’s Balance Sheet shows its overall financial position by listing accounts that are adding to or taking away from the value of your business. Also, potential investors will likely want to see the Balance Sheet before agreeing to invest.

Statement of Cash Flows

A Cash Flow Statement should answer the questions of when and where your business’s cash is flowing to and from. It may also be known as the statement of changes in financial position. This statement lists the financial activities of the business for a specific time period, including operating activities, investing activities, and financing activities.

One important thing to note about Cash Flow Statements is that profit does not always equal available cash; this is primarily due to the timing of when money is coming in and out of your business.

Why it matters: If you are struggling to have the available cash at the right time to pay bills or cover payroll for your business, the Cash Flow Statement can help you figure out why; this issue could be based on the movement of your business’s money in and out.

How to Read Business Financial Statements

If you are reading your business financial statements on your own and without much background business, financial, or accounting knowledge, it may not be as helpful to read each statement line by line. Instead, it may be helpful to ask yourself questions about the overall picture, including:

• Are my sales generally increasing or decreasing?
• Do I notice any trends developing?
• Have there been any unusual changes from previous months?
• Which expenses or expense categories have varied significantly?
• Based on this information, is my business on track for any goals I’ve set?

Pro tip: We like comparisons to previous periods to include a percentage of change for each account. It’s easier to compare periods in a single report, and that’s a great way to make significant changes or trends more noticeable.

Common Mistakes Business Owners Make

Aside from initial incorrect setup and data input, the common mistakes we see business owners make when it comes to reviewing their financials include:

• Only reviewing financial statements after year-end
• Only reviewing financial statements during tax season
• Looking only at revenue or profit
• Never comparing month-to-month results
• Never comparing actual results to the budget
• Not investigating unexpected changes
• Not reaching out for professional help with questions or for advice

Example in Practice: A construction company consistently showed a profit on its Profit & Loss Statement, so management assumed the business was doing well. However, the Balance Sheet and Cash Flow Statement revealed that customers were taking too long to pay invoices, creating cash flow problems even though the company was profitable. By monitoring receivables more closely and improving collections, the business strengthened its cash flow.

You Don’t Have to Interpret Them Alone

Even if you are a “solopreneur”, you don’t have to try to wear all the hats and do it all yourself. When it comes to your business’s finances, it may be helpful to have a trusted accountant, bookkeeper, or business mentor review your financial reports as well.

Whether your accountant or bookkeeper is fully handling your books or simply checking in a few times a year, it’s advantageous to have a second set of eyes looking at your financial statements to make sure you don’t miss anything important. With the guidance of a professional, you can use the information from your financial statements as tools to make well-informed decisions for your business.

At Grace & Growth Financial Services, we don’t just prepare financial statements for your business—we strive to help our clients understand what the numbers mean and how they can use them to make smart business decisions throughout the year. If you’d like this kind of trusted, caring support for your business, contact us today with your questions, to schedule a consultation, or to learn more about our services for businesses.

Resources

• SCORE
• QuickBooks