Breaking Down the Numbers and Understanding Financial Statements
6 min. Read
Last Updated: 05/07/2015
Table of Contents
At their most basic level, financial statements provide information about company performance. Even business owners who aren't accounting experts can gain important knowledge by understanding financial statements. The balance sheet, income statement, and cash flow statement each describe a company from a different angle, presenting business performance through a variety of viewpoints.
The balance sheet summarizes the financial position of a business at a certain point in time. As of the date of preparation, one side of a balance sheet details assets owned by the company. The opposite side shows how the company funded these assets through liabilities and equity. Both the left and right column on the balance sheet will total the same amount. In this way, the balance sheet solves the basic accounting equation of "assets equals liabilities plus owner’s equity."
When applying the accounting equation to a small real estate investment company, assets may include property owned and cash on hand, or in the bank. The liabilities listed provide clues as to how assets were acquired, typically through mortgage loan balances. The difference between these the assets and the liabilities would be equity, which contains any profit (or loss) from the business as well as equity contributed to the company by the owners.
Aside from property and cash, other examples of assets commonly noted on a small business's balance sheet include inventory, accounts receivable, or office equipment. Liabilities may include lines of credit, accounts payable, or other debt. Net income flows into the balance sheet through the owners' equity account, which increases or decreases at the end of each period, based on the company's profit or loss.
Also known as a profit and loss statement, or P&L, the income statement of a small business computes the amount of money a company made. Income statements may be broken out into revenue and expense line items to shed light on major money making activities. Manufacturing companies often present the income statement in multi-step format by first calculating a Cost of Goods Sold and subtracting these costs from revenue to calculate gross profit. Selling and administrative expenses would then be deducted from gross profit to arrive at operating income.
Operating income is one of the most important numbers gleaned from an income statement. To succeed over the long-term, companies need to make money from their everyday operations, rather than investment income or other extraordinary, non-recurring items. In the early stages of a company's life cycle, initial expenditures may result in an overall net loss, yet the company is actually building to increase future growth and profitability.
Cash Flow Statement
Cash flow analysis is vitally important for young companies in need of liquidity to fund operations. A cash flow statement begins with an opening cash balance and proceeds to account for all liquid funding going in and out of the company over a certain set period. Company management should review cash flow to determine if sales revenue noted on the income statement is truly collected from customers. Cash flow statements also show how outside funding is invested and used to purchase assets to help grow the company.
Many financial analysts use performance indicators to compare small companies to industry peers. Basic financial ratios are derived from amounts reported in the financial statements. For example, Return on Assets, or ROA shows how profitable a company is compared to the amount of assets owned. This is useful when comparing younger smaller companies to larger, more established companies in the same industry. Trends in ROA can also show if a company is becoming increasingly efficient as it grows. Return on Equity is another financial indicator that compares income generated to an owner's investment. Some companies can generate more income with lower initial investment, a trait which is viewed favorably by future investors looking for a larger return.
By understanding financial statements, and in particular how a company turns a profit, management can identify challenges they currently face and also which aspects of their business are most profitable. To assist with financial statement preparation, an online accounting system can help companies keep their financial information up to date and generate reports at the touch of a button.